Oct 25. Q: Low to negative rates not working? A: More
Some free-flowing thoughts this weekend, covering the PBoC and ECB easing, Valeant and stocks in general, the FOMC meeting, Business Insider’s most important charts, Illinois/pension problems.
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What accentuated the fall of stocks in August? It was the Chinese devaluation and the fear of a new wave of disinflationary pressure. The world has seen rolling waves of attempted currency devaluation with the Japanese really pouring it on in the beginning of 2013, followed by the ECB, and then by China.
This week Draghi signaled more accommodation and the Euro dropped from 113 to 110, the Schatz fell from -27 bps to -32 bps, and China eased. It seems as if the world is depending on the US consumer to suck up all the cheap[er] imports. Is it working? I don’t know if it’s causation or coincidence, but Walmart (WMT), probably China’s biggest customer, has lost a third of its value from the high of this year. Maybe that’s because AMZN is crushing the competition. Maybe it’s because higher wages are compressing profit margins…more on that later.
What happened to the most important commodity in the world? Oil fell to a new monthly low, down 6.5% on the week, partly related to dollar strength. Not exactly a sign that China’s ease is going to pull the world out of the global trade doldrums. Copper also closed at the low on Friday and was lower on the week.
However, stocks have soared this month as the weak employment data in the beginning of October apparently took Fed tightening off the table, and in the week just ended major tech companies posted better than expected earnings. Here’s a tidbit from USA Today:
Five of the best known executives in tech, Jeffrey Bezos of Amazon (AMZN), Larry Page and Sergey Brin of Alphabet (GOOGL), Bill Gates of Microsoft (MSFT) and Mark Zuckerberg of Facebook (FB), all together hauled in more than $10 billion in gains Friday from their stocks following astounding earnings reports. That’s a big slice of the $90 billion in total market value creation minted on Friday for all investors who own these shares.
Sort of points out a connection between Fed policy and income inequality. It also highlights the narrow scope of the stock market rally, which, by the way, was also the case in 2006/07. Nasdaq is within spitting distance of a new high. The Russell 2000 is still 10% below the high made in late June AND below September’s bounce. Maybe the generals will lead the whole army into new higher territory. But it’s an open question. The other aspect of low rates and a quest for return is the Valeant (VRX) strategy of growth through acquisition. Like a lot of things, it works until it doesn’t. From late last year the stock doubled through August; in the past 3 months it was cut in half with a vicious sell off last week. Sort of looks like the Shanghai Composite, maybe we can just throw the non-believers and accountants in jail. [VRX to hold conference call explaining its accounting on Monday].
Switching gears, there was notable put buying in Eurodollars over the past week. For example, on Friday January 9950 puts were bought in size of about 60k (open interest up 53k to 190, settled 5.5 ref 99.51 in EDH6). A bit over $8 million paid in premium on those. There has also been significant accumulation of red midcurve Dec 9900 and 9887.5 puts. There was a new seller of 25k 2EF 9812p at 4.5, so perhaps the front January puts are a simple flattening play. Why are we seeing all the front put buying? Either someone thinks the Fed is going to be hawkish and indicate it stands ready to hike in order to stop financial recklessness, or the wage and employment data is going to have a wicked rebound this month. My bet is on the latter. However, I don’t care how many regional Fed banks are requesting a discount rate hike (8), the Fed leadership cannot pull the trigger, especially with Draghi running in the other direction. The market may be considering the possibility, with the spread between Schatz and UST 2 yr up 8 bps on the week, but the odds are against a move by the Fed this year. Recall, there was also major put buying in December options for the hike in September. There are 3,604,115 EDZ5 puts of open interest, and the only ones that are likely to finish in the money are the 650 lots of 9975 puts.
In any case, the wage story is fluid. Business Insider regularly has a feature called “The most important financial charts” (link at bottom). There are 70 charts, 7 point to wage growth, 6 indicate profit and sales growth slowdown (in part due to higher wages, think WMT), and 3 say the bull market is still in place. I have never seen more space devoted to wage analysis. There was a think tank paper out this week which apparently also cited wage pressures. Jobless Claims are low, JOLTS data points to better labor markets. Wage strength should be the last piece of the puzzle for the Fed, but as David Rosenberg also points out in BI charts, the Fed mentioned “downside risks” in the Sept minutes more (12x) than any time since June of 2012. Having said that, a large part of the downside risk is due to China. This weekend news outlets carried headlines that Yellen is to give congressional testimony Dec 3, just two weeks prior to the FOMC. Big deal. The Fed is having an impossible time projecting US growth and inflation with the most up to date data in the world, let alone having to handicap China’s policies with murky data.
Speaking of downside risks, an article on Reuters about the financial disaster that is Illinois is worth a look. (Link at bottom). The state has unpaid vendor bills of $7 billion, over $100 billion in unfunded pension liabilities with another $63 billion just for Chicago, and is not paying lottery winners (even though sappy ads continue to run on tv featuring potential awestruck winners for the seasonal Halloween games). The article states that the governor proposed selling the State of Illinois building in order to save $12 million annually in operating costs. Hmmm…unpaid bills of SEVEN BILLION and we might save 2 tenths of 1% of that. Good call. I’ll tell you what’s spooky…not getting paid. Unfunded liabilities along with an aging demographic that is more dependent on medical care is a major downside disinflationary risk for the economy, and of course, it’s not just Illinois. Low stock and bond returns, uncertain pensions, higher medical costs. Not exactly encouragement for consumer spending.
In terms of trade strategy, I continue to favor steepeners over the long term, as the Fed can only move gradually, if at all. My larger view has been that risk assets have topped and are moving lower, that junk spreads need to widen further to correctly price risk, that the yen would trade higher to reflect the waning effects of QE. Things haven’t really worked out that way, so it makes sense to use options to limit risk.
Net changes in selected markets below:
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http://www.reuters.com/article/2015/10/24/us-illinois-budget-payments-insight-idUSKCN0SI0VA20151024
http://www.businessinsider.com/bi-most-important-charts-october-2015-10
http://www.businessinsider.com/dilbert-comics-on-bosses-2015-10
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Oct 23. If negative rates aren’t working, let’s make them MORE negative
–It’s all about liquidity, or about central banks boosting asset prices and depreciating currencies. Yesterday’s ECB press conference featured a very dovish outlook “…a rich discussion about all monetary policy tools …will reexamine degree of stimulus in December…discussed depo cut.” So the Schatz went to a new low yield under -30 bps. Italy and Spain 2 years went negative. Hard to believe US still at positive 60 bps…UK is 52. The treasury announced it was suspending next week’s 2 year auction, probably to prod Congress into action on the debt ceiling.
–Stocks exploded on prospective central bank stimulus. GOOG and AMZN beat at the end of the day. The euro was crushed, dropping over 2 big figures to just above 111. According to Reuters, “The Bank of Japan will cut its growth and inflation outlook for this fiscal year at a rate review next week but only slightly tweak its projections for next year, sources said, possibly tempering expectations that the central bank will soon ease monetary policy further.” If EUR continues to fall, further weakening EURJPY, then the BoJ will be compelled to also add stimulus. It’s the only game in town. Which will further encourage depreciation by China, thereby gutting the US (exporting) manufacturing sector.
–US yields didn’t change much by the end of the day, with tens down fractionally to 202.3. The curve was slightly steeper. Near the close there was a huge buyer of 100k red midcurve December 9887p for 1.5, some covered at 9915 with 10 delta. In every cycle, in front of the Fed and employment reports, there is heavy accumulation of front red midcurve puts. Those buys haven’t really panned out. However, given the weakness of the last jobs data, and the continued low level of jobless claims combined with JOLTS, perhaps this report will rebound the other way.
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There’s a movie called Wolf with Jack Nicholson and Michelle Pfieffer, where Jack, as Will Randall, says this:
You know, I think I understand what you’re like now. You’re very beautiful and you think men are only interested in you because you’re beautiful, but you want them to be interested in you because you’re you. The problem is, aside from all that beauty, you’re not very interesting. You’re rude, you’re hostile, you’re sullen, you’re withdrawn. I know you want someone to look past all that at the real person underneath but the only reason anyone would bother to look past all that is because you’re beautiful. Ironic, isn’t it? In an odd way you’re your own problem.
Paraphrasing for the Fed (and other central banks of the world)…
…You’re very powerful and you think the market is interested in you because you have sophisticated models, but you want them to be interested because the various economic agents actually do what the models forecast. The problem is, aside from all the impressive speeches and papers, the models aren’t working. You’re academic, you’re slow to react, your inflation forecasts are woeful, you’re miscommunicating. I know you want the market to look past all that and act like the models suggest, but the only reason anyone would bother to look past all that is because you’re powerful. Ironic, isn’t it? In an odd way you’re your own problem.
Oct 22. Stocks show signs of a turn
–ECB this morning; more accommodation on the way, though probably not at this meeting, more likely in December. Yesterday was a flattener in the US with twos down less than 1 bp in yield and tens down 4.1 to just 202.8. Similar move in euro$’s with red/gold pack spread -2.625 to just under 125 bps. Crude oil was notably weak yesterday with CLZ down over $1 late to 45.25. Crude oil inventories were higher than expected.
–Stocks were technically weak with key reversals in ESZ and NQZ (new high for the move, outside range day, lower close). On the fundamental side, CAT has had 34 consecutive months of lower sales…almost unbelievable. CAT share price put in a low of 63 at the end of last month, but is still below 70 currently, the lowest level in 5 years. American Express missed at the end of the day. But the big news was on the accounting side, with Valeant Pharmaceuticals (VRX) closing down 20% amidst accusations of Enron-like bookkeeping.
–In eurodollars, there was a buyer of 40k EDU6 9925/9950/9987 c fly for 5 bps. All of the large ED trades recently are of the same ilk…buy call flies for the roll up the curve while an impotent Fed sits on the sidelines, or at most hikes once. There are also buyers of long dated red straddles vs midcurves, a similar expression of a market going nowhere. Treasuries are on the same page; I marked USZ straddle at a new low of 10.5 vol. However, there continues to be protective buyers of Jan and March puts on EDH6, just in case the Fed does move. I would rather spend 6 bps on FFZ5/FFG6 calendar spread than 4.5 bps on EDF 9950 puts but the idea is the same; the Fed keeps telling us they are thinking of normalization so it’s prudent to have some insurance…
October 20. The poster child market
–Once again a quiet day with little movement in yields. Curve was marginally steeper as stocks maintained a bid; red/gold euro$ pack spread was up 2.75. Relatively large sell off in crude oil with Dec -144 to 4628. Mixed messages from the Fed, with early comments attributed to Dudley that a rate increase might be too soon this year, and late comments from Williams opining for a near term hike and then gradual increases thereafter.
–A little over a year ago, Stanley Druckenmiller called IBM the poster child for financial engineering management, noting that sales hadn’t increased in six years, but the balance sheet was deteriorating due to increased debt used for share buybacks. At the time, the stock was around 190. Yesterday it closed at 149 and is down another 5% after hours, having announced earnings with a cut in the forecast and another revenue miss ($19.3b vs $19.6 expected). Last Sept it was $22.4 for the quarter, and the Sept before that $23.3b.
–Note: more debt can make it look better for a while, but ultimately catches up. Increased debt without capital expenditures is not a growth formula. Speaking of catching up, Fitch downgraded Illinois yesterday…barely even makes the news any more.
–Today’s news includes Housing Starts expected 1.142m vs 1.126 last. Also, Powell speaks at 9:15 on the evolution of the treasury market, and Yellen gives intro remarks at 11:00 at the Labor Hall of Honor Induction Ceremony.
Oct 19. 5/30 treasury spread as leading indicator…
Attached are charts showing comparison of 5/30 treasury spread vs USD and Commodities (GSCI), and below that, 5/30 vs 2/10 and red/gold euro$ pack.
The top chart indicates that 5/30 peaked well before the dollar and also before the commodity rally. USD and GSCI moves were essentially simultaneous initially, though the dollar topped prior to the commodity index bottom (if indeed commodities have bottomed). It appears as if 5/30 has the potential to rally further to around 180.
The lower chart compares the 5/30 treasury spread with 2/10 and red/gold euro$ pack spread. Through 2014 these spreads moved pretty much in tandem, though again, 5/30 appears to be the leader. 2/10 and red/gold trade much closer than 5/30. However, since mid-August (when China devalued) the 5/30 spread has generally firmed and is near the high of 2015, while both red/gold and 2/10 have edged slightly lower. Perhaps this is due to China selling long dated treasuries. In any case, all of the curve spreads appear to have bottomed in Q1.
Keying off the 5/30, I tend to think that red/gold euro$ pack spread allows a fairly low risk entry point for a curve steepener. Low in red/gold has been just above 100 bps, currently around 124.
Oct 18. Monetary Lags
There’s a famous Milton Friedman paper about monetary lags, which he cited as “long and variable.” Policy makers have to first, identify the problem, second, respond to the problem with policy, and third, wait for the policy to take effect. Every one of those steps has a lag associated with it.
This week there was an interesting debate between the NY Fed’s Bill Dudley and John Taylor of Taylor Rule fame about whether to follow a rules-based policy (which eliminates some of the lags), or have a more activist Fed. Obviously, what we have now is the latter, and at times of increased financial stress there are, not surprisingly, going to be internal debates as to forward policy, which played out this week with Brainard and Tarullo speeches suggesting that the Fed refrain from tightening.
I reviewed a few academic papers on lags; this quote from a 2002 BoE piece sums it up: “We reaffirm Friedman’s result that it takes over a year before monetary policy actions have their peak effect on inflation.” .. “Bernanke, Laubach, Mishkin and Posen describe a two-year lag between policy actions and their main effect on inflation as a ‘common estimate.” *
I am no expert on policy lags, but consider what has happened in the year since QE tapering ended in October 2014. Since the onset of actual tapering in the beginning of 2014, commodities began their plunge, the dollar began to strengthen, inflation expectations began to fall. My view is that we are in the peak period of effects related to the end of QE. At the same time, as seen in the US budget data released this week, the Federal Gov’t, for better or worse, isn’t all that stimulative. [US Budget deficit at an 8 yr low of $439b]. As can be seen in the Fed’s Z.1 report, in the years between 2008 and 2013 the federal gov’t was a massive borrower to fill the gap for the private sector.** Now, the rate of fed’l borrowing has slipped to a growth rate of 5.4% in 2014 and just 2.4% in Q2 2015. Of course, we might say that’s as it should be, because the household sector has ended its deleveraging and Corporate Borrowing has bounced back and is expanding briskly from -1.2% in 2010 to +6.9% in 2014 and +8.5% average in the first half of 2015. The problem of course, is that much of the corporate borrowing has gone into share buybacks rather than productivity enhancing capital investment.
So, at the same time that fiscal policy has become less stimulative, we have the lagged effects of the end of QE and the forward looking response to a prospective rise in the funds rate. One of the effects/goals of QE is to force investors into riskier assets, to compress the spreads between, for example, corporate bonds and treasuries. What we are seeing now is the unwinding of those spreads, leading to tightened financial conditions as investors seek proper market-based risk parameters for corporate bonds (without the QE safety net). At the same time, with the threat of further tightening by the Fed, corporates borrowed more to lock in low rates, leaving corporate debt levels at a record dollar amount outstanding, $7.9T. An example of the end result is that the Baa corporate spread to 10 yr treasury moved from around 2.25 in early 2014 to around 3.25 now.
So what is the likely way forward? The market is obviously hyper-sensitive to changes in perceived central bank actions. The Sept FOMC announcement combined with a weak employment report vaporized the idea of a Fed hike this year, leading to powerful relief rallies in stocks and EM fx. Since the negative rate dot in the Fed’s Sept SEP, there has been relentless accumulation of ED 100 calls (0% strike) with 136k open in EDU6 and 122k open in EDH7. In the past week there were huge buyers of call butterflies in red midcurve June and Sept contracts, suggesting a slow grind flattening rally into next summer.*** The ten year yield is anchored around the halfway point of the year’s range which is 206; closed Friday 202.5. At 15.05, VIX is right back to the “fearless” level just prior to the August surge associated with China’s devaluation. Implied vol levels in treasuries are likewise at recent lows.
However, the dollar has gone sideways recently and is closer to the low of the year’s range rather than the high. Commodities are still weak, but are giving some indications of stabilizing. Similarly, the 5/30 treasury spread closed Friday at 152, near the year’s high, having started 2015 around 105 bps. The 5/30 spread almost appears to be a leading indicator, having topped over 250 in Q2 2013 as the taper tantrum peaked. It then declined through the end of 2014 to just over 100, and had a strong upward move in Q2 of this year to above 150. With the Fed likely on hold I think 5/30 should target 175 to 180 by year end, around the halfway mark of the 2013 high to 2015 low. The relatively long term trends of dollar strength and commodity weakness have likely run their course.
Given this thesis, the trades I favor are steepeners, like 5/30 mentioned above. In dollars, the red/gold pack spread settled 123 on Friday, only about 20 off the year’s low. Into 2016 I think this spread could move significantly higher. This year’s high has been near 160, which would be an initial target, and a move to 200 in 2016 seems reasonable.
In terms of the front end of the curve, I think two and five year yields are likely to move lower as the Fed’s internal debate forestalls any tightening over the near term, with the five year yield moving to 125 from the current 134.7.
It’s a fairly light news week in the US, with Housing Starts Tuesday and Existing Home Sales Thursday. International news could have the largest impact this week, with China GDP expected 6.5 to 6.7%. Additionally, the odds of a military accident between the US and Russia or even the US and China appear to have increased somewhat, with a possible flight to safety.
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*http://www4.fe.uc.pt/jasa/m_i_2010_2011/thelagfrommonetarypolicyactionstoinflation_friedmanrevisited.pdf
**http://www.federalreserve.gov/releases/z1/current/z1r-2.pdf
***+35k 0EM and 0EU 9925/9962/9987c flies for 11.5 as strip
Oct 16. All about liquidity
–Ten year yield rose 4 bps to 202. The market is comfortable around the 2% level, near the halfway mark of the year’s range. There was a new buyer of 15k TYZ 128/130.5 combo yesterday, paying 1 to 3 for the put around 129-05, 06 (settled 4 vs 129-025). However, downside appears limited and market makers continue to be weighed down by long call inventory.
–It’s pretty clear that the primary factor driving markets is perceived liquidity. It’s not earnings or revenue growth; we’ve had some poor results so far this earnings season. Many markets bottomed right at this month’s employment report, which substantially removed the odds of a hike this year. Since then there has been a big bounce in energy stocks, high yield, EM fx. For example, since Sept 29 the Korean Won has rallied 6%, though its export growth has remained negative (-8.3% yoy according to the last data). Dudley yesterday repeated that a rate hike could be in the cards this year. The market ignored him.
–US budget numbers were released yesterday, with the deficit at only $439b compared to $483b last year. Tax revenues were up 7.6% from $3.02t to $3.25t. Though there have been concerns about foreign central bank selling of treasuries, it would appear, from this data at least, that the improvement in the US budget lessens the need for treasury to issue as much debt, perhaps balancing out selling pressure from other countries.
–Today’s news includes Industrial Production, expected -0.3% and JOLTS.
Oct 15. Bowl a few frames this afternoon, beat the hike
–Wednesday started with weaker than expected economic data, with retail sales (ex-auto and gas) at 0.0 vs expected +0.3. Core PPI was -0.3 vs expected +0.1. And there was more bad news. Walmart was hit over 10% (evaporation of $21 billion of market cap) as the company slashed its outlook. The Beige Book was downbeat on manufacturing. Electricity output was down 1.5% yoy in the US. The State of Illinois said it will delay pension payments because it has no cash. Oh, and it will stop paying out lottery prizes greater than $600. A Cook County official (Chicago/ IL) announced plans to tax cable tv, golf and bowling. BOWLING! Really?
–Nearly all interest rate contracts tested the spike highs set on Oct 2 jobs data. Indeed, 2016 euro$ contracts exceeded the employment highs. Green euro$ pack surged 13 bps and the Five Yr treasury yield sank 8 bps to just 128, with tens -7.3 bps to sub 2%. All near euro$ calendar spreads made new lows. The peak one-yr spread is now EDM16/EDM17 which fell 4.5 bps to just 52. Hilsenrath piece late in the day suggested a hike may not occur in 2015. Thanks Jon. April 2016 Fed Funds closed +4.5 at 9972.5. Four FOMC meetings in front of it, and it’s only 15 bps under the front month. So you’re saying they might not hike this year?
–The dollar fell, and gold jumped $21 (late to $1186.5 GCZ5). The gold settle was the highest in three months. Both gold and silver closed above their 200 day moving averages.
–There were some large plays, for example new buyer of 35k 0EM, 0EU 9925/9962/9987c flies for 11.5. 0EM settled 6.25 and 0EU 5.25. Settle in for a long slow grind higher…
–Today’s news includes Jobless Claims expected 270k. Empire State -8. CPI -0.2 Core +0.1. Philly Fed -2.0 vs -6.0 last.
Oct 14. Black swans and fluttering red flags
–SPX down to 1400 by the end of the year? That would be a ‘black swan’ event. That’s so unlikely it would be like the Cubs going to the World Series. That would be like Playboy no longer showing naked women. Inconceivable!
–If there is one thing becoming clear to me it’s that US equity markets are extremely vulnerable barring extraordinary liquidity measures. Yesterday, the WSJ ran a piece noting “Cracks Emerge in the Bond Mkt” noting that rating agencies are ‘downgrading more US companies than at any other time since the financial crisis, and measures of debt to cash play are rising.’ This dynamic has been building for some time, as is obvious from the Fed’s flow of funds report. Corp debt is at a record (near $8T). The growth rate of corp debt was 6.9% in 2014, and in the first two quarters of 2015 was 8.4 and 8.7%. Sure, it makes sense to borrow when rates are low, but GDP has a much smaller relative growth rate…obviously the ratios are deteriorating. And JPM just reported a revenue drop of 6.4% and warned about the next quarter. Remember when Bear Stearns first announced problems with its mortgage backed funds? It was a huge engraved invitation to be out of stocks. However, after a bit of turbulence, stocks actually continued to ascend…for a while. Après… le deluge. Now UBS is closing its High Yield Plus fund, on the heels of Fortress shuttering its macro fund. FRAYING starts at the edges.
–If there were global signs of inflation picking up, or of a growth spurt, things might not be so worrying. However, China consumer prices just came out at 1.6% vs expected 1.8% (in an economy of 6-7% growth), and India wholesale prices were down 4.5%, the 11th straight month of decline. Inflation is muted everywhere.
–VIX settled yesterday at 17.67 and the Nov VIX future at 18.67. I am inclined to buy relatively near VIX futures and sell deferred. (thinking of Nov/Feb -1.10, but need to do a bit more work on this).
–In interest rates yesterday net changes were fairly small. However, near one-year spreads continue to shrink, with EDH16/EDH17 at just 54 bps, -2.5 on the day. There was a late buyer of 60k EDZ5 up to 9962 (open int -9k, appears exit). There was also a buyer of 50k FFX up to 9985.5 and this contract, surprisingly, showed an increase in open interest of 44k. New buyer at this level? Must have been Lael.
–Today’s US news includes Retails Sales expected +0.2, ex-auto and gas +0.3. PPI -0.2 with Core +0.1. Business Inventories +0.1. And in the afternoon the Fed releases the Beige Book in preparation for the October FOMC.
Oct 13. Oil hit / Brainard dovish
–Cubs win
–Thin trade Monday. The biggest change was crude oil which slumped around 4.5% (CLZ5 -221 late to 4794) in a delayed response to an increase in OPEC production numbers. Stocks were marginally better bid though HYG and JNK closed lower on the day. The curve flattened with red/gold eurodollar pack spread -3.875 to 123.5 (reds +1.25 and golds +5.125). Treasury futures were similar, with the 2 yr down around 1 bp and tens -3.4. EM currencies have had a strong spike higher since last Friday’s employment data which convinced many that a US hike is off the table. (Ind rupiah has been a star performer surging 9%). Fed comments have been mixed, but late in the day Brainard weighed in dovishly. (RTRS) “I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery – and argue against prematurely taking away the support that has been so critical to its vitality.” Earlier, Lockhart said labor mkt data supports raising rates. Backs liftoff by end of the year, but also says inflation risk is more to downside. US economy not highly exposed to China…but it may be negatively impacted through europe.
–This morning equities have turned south as China’s imports plunged 20% in September against an expectation of 15%. The US might not be “highly exposed” but it certainly reacts. By the way, China’s ten year yields below 3.25%, even with growth supposedly around 7% and fears of a hard landing…might already be in the midst of a hard landing.
–Fortress is closing its global macro fund with a ytd loss of 17.5%. Today’s news includes a speech by Bullard at 8 est. Other news includes NFIB small business optimism expected 95.5 (a bit lower than 42 yr average of 98).
