Dec 24. Atlanta Fed GDP Now estimate slashed by 30% for Q4

–Economic news continues to be disappointing.  After yesterday’s releases, the Atlanta Fed GDP Now estimate for Q4 went from 1.9% to 1.3%.  From the release: “The nowcast for real residential investment growth fell from 8.0 percent to 0.9 percent after yesterday’s existing-home sales release from the National Association of Realtors.”  Hasn’t it been the first quarter that has recently been the weak one?
–Yields edged slightly higher yesterday with the 30 yr bond yield testing the 3% level.  Oil continued to rebound, helping to relieve pressure on high yield, in turn helping stocks to rise.  Jobless Claims today expected 270k.
–Premium under pressure as we go into today’s treasury option expiration.  Today’s January 126^ was trading 15/64’s at yesterday’s close with futures right at strike.  I marked USH atm vol sub 10%.
–I continue to read conflicting reports regarding the farce otherwise known as student loans.  There’s a piece on Bbg today that Fitch miscalculated the amount of student loan bonds that they might downgrade to junk…“In a corrected estimate, Fitch now says the value of bonds on review for downgrade is actually $71.2 billion.”  The debt is not being serviced, which in a way is a reverse form of stimulus.  Here’s a quick link, http://www.huffingtonpost.com/entry/congress-student-loans_567177cae4b0648fe3019fe7
The article claims that students will get better service and will be less likely to default because Congress is shifting more of the loans to smaller contractors that have better collection rates.  Does that make any sense at all?  “By directing more accounts to smaller loan contractors, representatives of those firms say, both taxpayers and student borrowers stand to benefit because borrowers at risk of falling behind will get the attention and service they need to make good on their obligations and avoid defaulting on their debts.”  I know I write some stupid stuff from time to time, but if there’s anything this blatant please call me out on it.  ‘Attention and service’ is known as aggressive collections.  JOBS are what helps to service debt.  Maybe those former students can get new jobs as debt collectors.  Oh, and Merry Christmas!

Dec 23. “Know before you owe”

–Yields edged higher yesterday with a slightly steeper curve.  Tens rose 4.3 to 223.8, as stocks rose and pressure abated on high yield and oil.  Volume was light.  January treasury option expiration is tomorrow.
–Existing home sales were much weaker than expected, adding another data point to a string of disappointing economic releases, though the NAR website explains that closing dates have been delayed due to another government initiative, “Know before you owe”. The NAR economist also said “Sparse inventory and affordability issues continue to impede a large pool of buyers’ ability to buy, which is holding back sales”.  So, not much to be taken from this report… however, the amount of global government interference just seems to continue to rise.  Whether it’s Dodd-Frank constraints on dealer inventories, Obama care and the associated rises in insurance premiums and deductibles, or even the more mundane things like clogging of traffic due to bicycle lanes, commerce is impeded.  In fact, the latter item likely added 5 minutes to my taxi ride to the pub after work (thankfully I was able to catch up).  In another startling example of gov’t at work, I read this morning that Japan owns over HALF of the country’s ETFs.  In the 1980’s they used to call it Japan, Inc. in admiration of gov’t and business working together to build a powerhouse.  Now it’s simply gov’t ownership in hopes of stimulus.
–Interesting story on Bloomberg this morning.  http://www.bloomberg.com/news/articles/2015-12-22/man-who-called-china-s-boom-and-bust-now-warns-of-crisis-risks
“Historically, every time the U.S. current account improved, concurrent with dollar strength, some country somewhere in the world plunged into some sort of crisis,” Hong said. “The pressure from a Fed tightening and thus a dollar liquidity shortage scenario will more likely show up” in Hong Kong property as well as China’s online lending and high-yield corporate bonds, he said in an interview.
–US econ releases today includes Personal Income and Spending +0.2 and +0.3.  Durables expected -0.6 but 0.0 ex-trans.  New Home Sales 505k.

December 20. Dislocations

In this business, we’re always trying to identify market ‘dislocations’ that we can exploit. Sometimes, these are little kinks that market technicians refer to as ‘mean reverting’ (or what Keynes might have referred to as irrational…as in ‘the markets can stay irrational longer than we can stay solvent’). What’s probably one of the biggest dislocations ever is right under our noses, or in this case, pictured in the chart above. SPX versus the Bloomberg Commodity Index. Commodities are at multi-year lows, while stocks tentatively churn near the highs. With energy accounting for about 35% of BCOM, and oil probing ever lower, the lower right hand part of the chart is understandable. However, as has been well-documented, that same dynamic has spilled over into higher (much higher) financing rates for energy companies, and for miners, and has been reflected in prices such as the Canadian dollar vs USD, at a new low of 71.65 cents (1.3957).

I have several times cited a fascinating article that highlights the reduced amount of energy and material used in our modern world for basic functions. For example, an i-Phone can replace a bulky alarm clock, a stereo system, a camera, shelves of records and books, etc. That’s part of the answer. But still, don’t we still need industrial materials to make cars? Or bombs? (both of which are seeing high demand). Not really… instead of B1 bombers, drones. Instead of tanks, cyber warfare. For example, I saw a few links (thanks AOK) noting ‘Turkey under Cyberattack from Russia’* and on CNN, ‘Newly discovered hack has US fearing foreign infiltration’** One U.S. official described it as akin to “stealing a master key to get into any government building.” [Links below]

So obviously, some of the demand for raw material has declined. But there are still companies that produce and transport things, with employees that extract energy and metals. Those companies have debt, money lent which could now be impaired or disappear altogether. So there’s a loopback into financial assets. Note as well that our entire financial infrastructure rests in clouds of ether data. Want to see dislocations? The risk is there.

Finally, last week we had Fed liftoff. Time will tell whether rates and the economy will ascend, or whether this is more like the special delivery Acme Rocket Blaster that the coyote straps on to pursue the roadrunner, only to find himself spiraling down the abyss of the canyon.

Some respected analysts think Fed hikes will come more quickly than currently priced into the market. [Another big dislocation?] For example, Steen Jakobsen, Saxo Bank’s CIO and chief economist: “Fed says four hikes, market says maximum two – I’m with the Fed.”   Or David Kelly, chief global strategist at JPM Funds. (BI) Kelly is of the opinion that the economy is strong enough to sustain not just the rate hike from the Fed seen on Wednesday, but a brisk pace of rate hikes going forward. “That is just a wrong forecast,” Kelly said. “The unemployment rate will come down more than the Fed expects and that will keep their feet to the fire for more rate hikes.”

Well the market isn’t holding anyone’s feet to the fire just yet. As mentioned previously, the peak one-year Eurodollar calendar spread remains below 5/8%. EDH16/EDH17 closed at 59.5 Friday, up just 3 bps on the week. Both the red/gold euro$ pack spread (2^nd to 5^th years) and treasury 2/10 closed at new recent lows, and near the lows of 2012. Actually the red/gold spread is well below 2012 at just 93.5 bps, and 2/10 at 124 is within shouting distance of the low set earlier this year and the low of 2012. So I’m with the coyote on this one, and will go along with the (interest rates) market. The Fed will have to order something else from the Acme catalog. And the stock market will stop in suspended animation, look directly into the camera for a frame, followed by a descending whistle.

We can get a sense of the odds for a hike in March by looking at near contracts. April Fed Funds closed at 99.525, or 13 bps below the January contract (99.655) and since April is a relatively “clean” month (April 27 FOMC), we can say odds of a hike in March are just better than 50/50. March Eurodollars on the other hand, seem to indicate even higher odds of a hike in Q1.   EDZ5 just expired at 99.4822 having priced the hike. Therefore, one might expect EDH6 to be around 9923 if it were fully pricing a March move, vs the settle Friday of 9929. So EDH6 is reflecting higher odds than FFJ6, more like 3 out of 4. However, some of this could reflect a demand for dollar funding which may abate going into the new year. (Sell FFJ and buy EDH?).

One other thing that people constantly mention, and I’ll admit that I’ve previously been in this camp myself, is that the new generation of traders and investors have never even seen rate hikes, and won’t have any idea how things might unfold. “These kids have never even seen Fed funds at 5.25%.” Well, I’ve met a lot of brainy “kids” in the business that can dance circles around me, and have technology at their fingertips to study and sift historical relationships. New generations come, and while experience provides valuable insights, the drivers of fear and greed are always there, and there’s plenty of data documenting the ebbs and flows. But the one thing I will say is, Trade with the trend. Let’s hope there IS one in 2016. I remember seeing an interview with Tom Baldwin in 1994, at the time the biggest local in the bond market. At the start of 1994 we had three hikes in rapid succession. Bonds tanked. At first Baldwin mentioned that he was trying to fight it. But then he said, “the market went down a few points, and just kept going, so I jumped on.” We’re just not seeing that price action in the current environment. In fact, implied vol in treasuries was hammered this week. For example, last Monday the USH 155 straddle settled 6’08 ref 155-14 (11.5). On Friday, USH 156 straddle settled 5’16 ref 156-12 (10.3). That’s a lot of vanished premium. Where’s the bond bear? Snoozing.

Having mentioned the importance of trend, I will also say that oftentimes the new year brings trend reversals. New money comes in to certain sectors and abandons others. One of the pieces of market history that I buy into is the idea that the dollar strengthens in anticipation of hikes and begins to weaken after the Fed starts. It happened at the onset of the 2004 hike cycle, though the dollar firmed through 2005. On a long term chart of DXY, the high in 2002 (set in the beginning of the year) was 120.50 and the low in 2008 (set in the beginning of the year) was 70.70. The 0.618 retrace is 101.50 and we’ve recently come close just above 100.

If – and it’s perhaps the big question of the year – if the Fed becomes hesitant to hike further, then the USD should begin a decline and the US curve should steepen. It would also likely mark an end to the divergence of the lead-off chart.  In terms of general trading strategy, it’s tough to be short interest rate vol after the drubbing taken this week. Weaker stocks and hi-yield should engender risk aversion which should support green Eurodollars on the curve (small outperformance Friday) and Fives in treasuries. Into the end of the year and holidays, conditions will be thin; no specific trade recs at this time…

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Dec 18. F L A A A A A T

Industrial Production…negative yoy. Miss by Philly Fed today

Below is a chart of Industrial Production year over year, Philly Fed, and Mfg ISM.  Doesn’t appear to be the type of set-up that would spur inflationary juices….

I just set this up because I had not realized that Ind Production year-over-year was NEGATIVE.  How does that happen with auto sales at 18 million unit pace?

Stocks priced in commodities…parabolic

This is an update of a chart I have previously sent…SPX priced in terms of BCOM…the Bloomberg Commodity Index.  Parabolic, as strong dollar has hurt commodities, along with faltering global trade and weaker demand.  Completely opposite moves in commodities and stocks.  Paper…not things.  [SPX/BCOM]

Dec 17. Gradual vs transitory

–The Fed finally hiked, and though the interest rate markets were well prepared there were some notable moves.  Implied vol was crushed in interest rates, down about 0.5 in TYH, and most eurodollar straddles were down 1.5 to 2.5 bps. ATM TYF straddle was 1’04 in the morning but settled 0’52.  The USD strengthened and commodities are pressing new lows this morning.  It’s also worth noting that the Chinese yuan is again weaker, at 6.4837 vs 6.4726 yesterday…new lows from the August devaluation.  Taiwan actually cut its discount rate from 1.75 to 1.625, and Brazil (yesterday) was cut to junk. January crude is nearing $35/bbl this morning.  All related to disinflationary pressures.
–I am trying to determine the difference in time between “gradual” and “transitory”.  As in, the Fed is supposed to raise rates gradually, but factors holding down inflation have been transitory…for at least the past two years.  As Yellen noted in the press conference, oil doesn’t have to necessarily go up to make a positive contribution to inflation, it just needs to stop going down.  In the econ projections, the Fed has Core PCE inflation tantalizingly close to 2% in 2017, at 1.9%, then finally hitting the mark in 2018.  (As a comparison, consider what Putin said, that a price of oil for $50 in the official budget is too high and needs to be adjusted, since it’s already $35). Pragmatism vs hopes and dreams.
–In terms of hard data, Industrial Production yesterday was -0.6%.  Year over year IP is NEGATIVE, having been running as strong as +4% in the latter part of 2014.  Today’s news includes Philly Fed, which is expected 1.2 from 1.9.  Again, for the sake of comparison late in 2014 it was 40.  I know….we’re a service economy now and all UBER drivers, so manufacturing is meaningless.  (On a side note Washington DC is installing more speed cameras and increasing speeding fines up to $1000).  Other news today includes Jobless Claims expected 270k and Leading Indicators +0.2.
–Late yesterday there was a 30k block buy of EDJ 9912/9937/9962 call fly 1x3x2 for 6.5.  On Monday same structure bought in June (EDM) for 4.0.  These trades work if the Fed skips March, leaving June with 50/50 probability…in that scenario EDM should be trading around the middle strike.  If the Fed moves in March, leaving uncertainty for June, the trades could still be net positive.
–One last note.  The Fed is increasing the repo facility to $2T.  For those who are interested, “The results of these operations will be posted on the New York Fed’s website. The outstanding amounts of RRPs are reported on the Federal Reserve’s H.4.1 statistical release as a factor absorbing reserves in Table 1 and as a liability item in Tables 5 and 6.”

Dec 13. Yields are high because they AREN’T liquid

It was a volatile end of the week. VIX settled at its highest level since the end of September at 24.39. Stocks tumbled Friday with SPX down 3.8% on the week and the Russell down 5%. In a sign of EM fragility, the Mexican Peso closed at a record low, and the Chinese yuan also hit a new recent low. High yield ETFs were crushed to the lowest levels since 2009 when we were pulling out of the worst of the crisis. I have mentioned deterioration in high yield many times, but the fabric continues to fray. On Dec 10, Third Avenue Focused Credit closed, “…and placed the fund’s remaining assets into a liquidating trust. The trust will make distributions to the fund’s shareholders as income is received and assets are sold. Third Avenue expects the liquidation to take up to a year or more to complete.” Then on Friday, Stone Lion Capital, a distressed bond fund, suspended redemptions due to, well, requests for redemptions. My old friend Larry had a classic line for this type of a situation, “I don’t want the cheese anymore, just help me get my head out of this trap.” Investors are starting to squeeze through a small exit door. The Morningstar article from which I quoted above starts with this headline:   “The demise of Third Avenue represents a profound management failure, but it isn’t likely that we’ll see other high-yield funds follow suit.” (Except for two days later). Apparently the “profound failure” was that the fund invested in illiquid bonds. Yup, that’s what the article says. But then was unable to easily unload them. That’s some fine investigative work there, Lou. And it goes on to note. “As we approach a likely Fed rate hike next week and the holidays, market liquidity could well take a hit.” Hmmm, you don’t say. I’m glad Morningstar thinks that contagion isn’t likely, though I’d feel much better if I heard it from someone higher up, say, at the Fed. Because when the Fed says something is contained, well….you know the rest. By the way, in the 2008 meltdown the problem was mortgages, and the Federal Gov’t became the mortgage market. This time it’s much different. Is the gov’t going to step in and support corporate debt?

Early in the year, when the market was debating the idea of a September or December hike, I recall one analyst specifically saying the Fed should go in Sept rather than tighten at an illiquid time, year end. That would have been prudent. However, now we’re faced with a hike this week. The short end has priced it in; in my opinion it would be folly to hold off now. The challenge is for the Fed to slow expectations on trajectory without belying concerns about the economy falling into a negative spiral.

I’ve read many notes about the Dodd Frank rule changes that have caused dealers to pull back on inventory, and generally have contributed to technical pricing anomalies (Negative swap spreads, etc). I really am not familiar enough with the regulatory minutia to form an opinion on ultimate outcomes. What I do understand is this: QE was designed to make market participants take more risk and compress spreads down to unreasonable levels, so that companies would take cheap financing and invest in new jobs-producing projects. The investing turned out to be mostly financial. The withdrawal of QE has reversed this process over time, unwinding the artificially pricing of debt, and high pricing of risk assets. At the same time, in the big picture, the regulatory environment has served to push things in the same direction, that is, the Fed is withdrawing support for risk while the regulators have warned big banks to shun taking risk. And now the Fed is further tightening money market conditions.   When’s the last straw? One can look at the financial stress charts attached and say that conditions aren’t yet problematic. And that might be right, but Bear was in 2007 and the Goldman financial conditions index didn’t really surge until mid-2008. In other words, it didn’t exactly provide the tsunami warning. In fact it might be Cleveland that indicates the most foreshadowing.

(White line is Chicago National Financial Conditions, Gold is GS Financial Conditions, Green is St Louis and Pink is Cleveland Fed Financial stress).

On the week the Eurodollar spreads declined.   The peak one year spreads are EDH16/EDH17 and EDM17/EDM18 and they’re both just 56.5, indicating around two hikes per year. March’16/17 declined 7 bps on the week.

Many analysts are suggesting that the dots will play a big role in how the Fed provides forward guidance. Kocherlakota won’t be participating, so hopefully that will eliminate the negative dot. The dots for year end 2016 (mean) have progressed over time as follows: In March, the 17 dot mean fell nearly 52 bps to 2.02%. In June it fell another 27 to 1.75%. In September another 27 to 1.48%, and now it has to come down again. EDZ’16 is currently 98.92 or 1.08%, consistent with funds under 1%. I wouldn’t be surprised to see the 2016 mean come down to 1.25%. I really don’t think the dots provide any value at all, except for providing clear evidence that the Fed follows the market, with a lag.

What I did on the attached table is to look at the quarterly contracts starting six months after the FOMC meetings, and specifically look at the two year spreads, white to green and red to blue. I don’t draw heavy conclusions from this except to note that we are going into the Fed with the six month forward contract, currently EDM6, at 9921.5, at the lowest level of any six month forward contract so far. Not too surprising, the Fed has told us they’re going to hike. However, white to green and red to blue spreads are also the flattest they’ve been, both before and right after the meeting. These spreads are indicating a market that is at best skeptical of the Fed’s ability to engender inflation. EDM16/EDM18 is currently just 99.5. The same relative spread was 118 at the last quarterly FOMC and 153.5 the time before that. EDM17/EDM19 is just 73 bps and was 97.5 in the previous qtr and 108 the qtr before that.  On a longer time frame basis, I think back spreads like EDM17/19 is too cheap here, especially if the Fed signals “one and done.”

Sometimes it’s just this simple (as described by Billy Ray Valentine in Trading Places). “Hey, we’re losing all our damn money, and Christmas is around the corner, and I ain’t gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain’t gonna f… my wife ain’t gonna make love to me if I got no money!” So they’re panicking right now, they’re screaming “SELL! SELL!” to get out before the price keeps dropping. They panickin’ out there right now, I can feel it.

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Dec 11. Time to hide

–This morning oil is making new lows, China’s yuan is at a new low 6.4552, Canada dollar at a new low.  Junk bond funds continue to crash, Brazil is sliding into junk territory.  Massive mine layoffs.  Thank goodness we can hide our money in Amazon stock, with its p/e of 959.  (No one will ever notice us hiding here…)
–Today brings Retail Sales expected +0.3 across the board, and PPI, expected 0.0 and +0.1 core.
–Yesterday’s trade featured buying of puts up front, for example EDF 9925 puts bought for 1.0 (appears to be unwind related to 95/93/92 put flies) and there was a new buyer of 30k EDU6 9875 puts for 5.0.  Curve was steeper as red/gold pack spread closed 104.375, up 4.75.
–One thing that I mentioned yesterday deserves more attention today.  I saw a note citing DB saying that corporate debt is at a % of GDP (42-44%) where previous credit default cycles kicked in.  So the Fed’s flow of funds report came out yesterday.  In this report Business debt is broken down into two categories, Corporate and Total.  As of Q3, Corp debt was 8046.7b against GDP of 18064.7, so a bit over 44%.  (This is the warning zone DB mentions).  But TOTAL business debt was 12621.4, or 70.0% (!!) of GDP.  I looked back at other times (approximately) when default cycles kicked in, the end of 1988 and end of 2007.  In 1988 GDP was 5412.7 and Corporate debt was 2263.0, or 42%.  Total business debt was 3405 or 63% (so total was less than now).  In 2007 GDP was 14685 and Corp was 6336 or 43%.  Total was 10112.4 or 69%.  One might argue that it’s no big deal now because rates are so much lower, but spillover from junk along with the rate hike and…there will be blood.
–The other thing to notice about the flow of funds is this.  First, American’s net worth declined by $1.2T on the quarter, the first drop in 4 yrs. The press always trumpets the fact that net worth is going up, but with the declines in US equities going into the end of Q3 it didn’t happen this time.  What I tend to focus on a bit more than net worth is growth rates of various sectors in the economy.  In fact, the past quarter showed a deceleration in several borrowing categories.  Total business went from 7.2% growth in Q1 to 8.4 in Q2 to just 4.7 in Q3.  State and local govt’s went from 3.0 in Q1 to 1.0 to 1.7% now.  Fed govt was -1.1 +2.4 and +0.2.  The strongest debt growth was in Consumer credit, 5.6% Q1 , 8.5 in Q2,  and now 7.2%, and we know that’s due to student loans and autos.  I’m going to slap the Make America Great Again sticker right on the back of this new F-150 (which I’ve financed for the next 7 years).

Dec 10. New lows ED spreads —> gradual

–Was yesterday just a little hint of what’s to come?  Front eurodollar calendar spreads at new lows tells you all you need to know.  For example, EDH6/EDM6 made a new recent low at just 14 bps.  Does 14 bps for a near three month spread reflect a hiking cycle?  EDH6/EDH7 one-yr spread made a new recent low of just 59 bps, less than 5/8%.
–So if the Fed validates the market and projects really, really, really gradual rate hikes, how might other markets react?  The dollar’s strength has been in part predicated on a hike “cycle”, so the dollar could give ground (as happened yesterday).  In fact, there’s a chance the dollar index has formed a double top, with the recent high testing the March level just above 100, pulling back at the start of this month to end yesterday at 97.35.  Risk assets could see further deterioration as was seen yesterday.  The curve, from greens back steepened slightly, and there was a slight flight to quality in the belly.
–From another note citing DB: “Corporate leverage is at the point where previous default cycles starting kicking in” with nonfinancial debt at 44% of GDP.  The Fed’s Z.1 report is released today which will have summary statistics of debt levels and growth of various economic sectors.  We already know that corporate debt in absolute numbers is at a record level.  But as this metric also gains as a percent of GDP while the debt markets have started demanding higher rates to compensate for risk, the specter of forced deleveraging rises.  On a related note, ratings agencies are poised to downgrade Brazil to junk, and the US Senate declined Puerto Rico’s request that some municipal entities could declare bankruptcy.  The point is that there’s been an increase in risk, and the Fed will be sensitive to that as it discusses trajectory.
–Jobless claims today expected 270k.  China yuan at new low this morning 6.4386.

• 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.