October 12. QE lag times

–Just a few quick broad notes as I missed most of the action last week.  First, from Reuters: A report by the Group of Thirty, an international body led by former European Central Bank chief Jean-Claude Trichet, warned on Saturday that zero rates and money printing were not sufficient to revive economic growth and risked becoming semi-permanent measures.
“Central banks have described their actions as ‘buying time’ for governments to finally resolve the crisis… But time is wearing on, and (bond) purchases have had their price,” the report said.
–This thought echoes that of Blackrock’s Peter Fisher, who on employment Friday one week ago said that the Fed’s ability to stimulate through monetary policy is played out.
–Yesterday, Stanley Fischer said that the Fed is likely to raise rates this year, but that is “an expectation, not a commitment”, and could change if the global economy pushes the U.S. economy further off course (RTRS).

–In many ways, the end of QE purchases was a much larger tightening event than a potential FF target increase.  One of the outcomes of QE was to push investors into riskier, longer term assets.  Without QE these assets have to seek more realistic levels, which has been occurring, but there is obviously a long lag time.  Because there haven’t been historical episodes of QE until recently, there’s little research on how those lag times play out.  As a side note, Peter Fisher also mentioned that the Fed’s models didn’t, until recently, take into account financial market volatility measures like the VIX.  QE also had the effect of suppressing volatility.  By allowing the MARKET to tighten conditions, the Fed HAS tightened.  But I haven’t really heard any Fed official say that.
–In Japan, it’s becoming pretty clear that QE has already played out.  The first effect was to weaken the yen, which stimulated exports.  But other countries eventually follow suit.  The weaker yen causes import prices to increase, but if wages don’t keep pace (which is the case) then the effect on consumer spending is negative.
–In the US the “expectation” of a hike has strengthened the dollar, in turn slowing global trade, and pushed the inventory to sales ratio in the US ever higher.  From BI, “…earnings growth for the companies in the S&P 500 have been negative for 2 straight quarters, which rarely happens outside of recessions.”
–Though last week was a big risk relief trade, the longer term picture is that assets still need to seek more appropriate market based values.

Oct 2. Flat curve going into payrolls. Demand for physical.

–Employment report today with NFP expected 200k.  Going into the data many curve spreads are at or near their lows.  For example 2/10 treasury made a slight new low just below 140 bps.  Euro$ one-year calendar spreads are all right at their lows, with a peak of only 55.5 bps.  Many argue that these spreads are too low, but, like the weather, no one seems to do much about it, either because they want to keep their powder dry or have already run out of ammo.  Easy risk/reward would appear to indicate more downside than upside in terms of bond prices, but I’m not so sure.
–From the Atl Fed, a big drop in Q3 estimate of growth. “The GDPNow model nowcast for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2015 is 0.9 percent on October 1, down from 1.8 percent on September 28. The model’s nowcast for the contribution of net exports to third-quarter real GDP growth fell 0.7 percentage points to -0.9 percentage points on September 29 following the advance report on U.S. international trade in goods from the U.S. Census Bureau.” [dollar strength killing net exports]
–In other news, Treasury Sec’y Lew says the US will run out of money on Nov 5.  Here comes the debt ceiling fight, exactly a year before the election.
–Auto sales yesterday were much stronger than expected at an 18.2 million unit rate.  Cheap gas along with cheap financing and lengthening terms.  Seems stretched.
–I jotted out a note yesterday about visiting a coin dealer and the premium over spot on silver American Eagles was $6, 40% of the spot price and double the premium of a few months ago.  Sure enough, there is a story on Reuters today citing a huge shortage of physical coins, though one source blamed a crunch in manufacturing capacity. http://mobile.reuters.com/article/idUSKCN0RU30220151001
In an interesting juxtaposition, I saw a story that sugar has exploded in price, from 11.00 to 13.24 in a few days (a 20% gain) because one big user took delivery.  Makes one think about an increase in physical delivery, on precious metals for example, relative to all the paper claims on the physical.  Commodity markets have already been roiled.  If there is one thing that could take the air out of bond bulls it would be a torching surge in commodity markets.  Having said that, I would note new lows yesterday in HYG and JNK, in spite of an up market.  Some paper claims are already getting torched.

Sept 29. US rate markets forecast Ice Age. India cuts 50 bps to 6.75%

–Though it wasn’t a large volume day in interest rate futures, there were a number of notable features.  The ten year yield dropped just over 7 bps to 209.5 as SPX fell 2.6% and Nasdaq fell 3%.  All euro$ one-year calendar spreads flattened to new lows, for example the peak one-yr spread is EDH16/EDH17, now at only 57 bps, down 3 on the day.  The red/green pack spread is just 48.25 bps, also a new low.  Red/gold pack spread (2nd to 5th year) closed just under 125 bps.  2/10 treasury spread crushed, down 4.7 bps to just 142.7.  Finally, in terms of inflation expectations, Ten yr note to tip spread fell to a new low of just 141 bps, down nearly 7 on the day.
–Equities were of course weak, with the Russell leading the charge as it closed on a new low for the year.  Precious metals were routed, likely due to Glencore’s misfortunes.  High yield etfs HYG and JNK both went to significant new lows for the year.   However, the VIX rally was underwhelming in response.  On Sept 1, Oct VIX was 25.82 with ESZ 1907.  Yesterday (at the settle of interest rate futures), I marked ESZ 1872, or 35 points lower, while the VIX was lower as well, at only 24.4.  So there’s a bit of divergence which could presage a short term bounce.
–Carl Icahn is warning of a financial doomsday, while at the same time endorsing Donald Trump.  I guess the only proper hedge for that is to buy Eurodollar 100 calls, which is what someone did yesterday.  The 100 call strip in EDU6/EDZ6/EDZ7 was bought for 2.0 in size of 20k and an additional 50k EDU6 100c bought for 0.5, leaving open interest in the latter just under 100k.

Sept 27. Stress tests

There’s a classic definition of stress that I have often felt:

“The confusion caused when one’s mind overrides the body’s natural desire to choke the living sh*t out of some a**hole that desperately deserves it.”

By now, people are aware of Janet Yellen’s speech last Thursday where she seemed confused and began to choke, notably just before concluding with this: “Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.” It was a long speech, so it’s probably not exactly fair to say this, but maybe she really doesn’t think it IS appropriate to hike later this year, maybe that’s what she’s choking on and confused about…her colleagues are pushing for a rate hike and rather than going with her own analysis, she is being stressed into it. Hence the caveat about economic surprises.

The Fed requires strong leadership. It’s a tough job to keep divergent opinions in line. Case in point, John Boehner, who just resigned his House speakership rather than face an uprising from the far right. From the analysis I’ve seen, this move will likely avert a government shutdown in October, but going into the end of the year, a huge fight looms over a debt ceiling increase and…a gov’t shutdown. This issue is likely to dominate the news going into December. Does that fit into the idea of an economic surprise? In my opinion it significantly reduces the odds for a hike this year. If it doesn’t happen in October, it surely won’t happen in December. Of course, the Fed could ignore the political discourse, and send a message from ALL central bankers to ALL governments, that it’s not solely up to monetary policy to keep the engine humming. But I doubt it.

We just came off a strong revision to Q2 GDP growth of 3.9%. However, the Atlanta Fed’s GDP Now estimate for Q3 is just 1.4%, and has been hovering between 1.3 and 1.5 since mid-August. Earnings estimates for Q3 are expected down 3.9% year over year. Market based measures of forward inflation are hitting new lows, for example I marked the ten year note to tip spread at just 148 bps on Friday, a new low for the year. It started the year at 170. It’s hardly compelling to argue that the Fed’s behind the curve.

What about current market indications of stress? Whether one looks at junk bond spreads, or financial stress/conditions indicators published by many of the regional Fed banks (Chicago, Cleveland, KC or St Louis), they have all turned higher, indicating potential problems. [Links below]

What about swap spreads? They usually widen during times of stress as market participants rush to the safety of treasuries. But now they are plunging. The five year spent the first half of 2015 between 10 and 20 bps, but has now collapsed to a new low of 1.75. The ten year was between 8 and 15 bps in the first half, but has cascaded to -2, testing levels not seen since 2010 (fives are actually below 2010 marks). The reason given, in part, is that foreign central banks are unloading UST reserves in support of their own currencies. Perhaps the market also realizes that central banks will do everything in their power to save financial institutions. Does too big to fail ironically cause swap spreads to come under pressure during episodes of stress?

The Nasdaq Biotech Index (NBI) closed at a new low Friday, down 22% from July’s high, essentially a round trip from the beginning of the year. The VIX was only 1.3 higher on the week, but remains well above 20, closing at 23.6. We’re all aware of stress in the energy patch, and in commodities in general. Lumber at around 216 is as low as it’s been since 2011, almost half off the high in 2013 of 400. Same with copper, which closed at a new low for the month of September, and is nearly 50% below the price of five years ago. Perhaps the low input prices, including interest rates, are good for homebuilders, but trying to re-pump global demand back to unreasonable levels with a monetary compressor just doesn’t seem feasible. Are more ‘normal’ commodity prices suggesting that interest rate ‘normalization’ should also occur? Maybe that would be the case if there wasn’t an overhang of debt servicing costs to contend with, but there is, hence corporate bond spreads widening.

For now, there seems to be an overwhelming preponderance of negative news that is likely to pressure risk assets. Lower prices for risk assets will likely translate into lower interest rates. The big events of the week are Dudley’s interview on Monday with the WSJ, Stanley Fischer’s speech Friday on Macroprudential Regulation, and, of course, the jobs report on Friday. Jobless claims have been quite low, and there are several other factors which indicate the risk of a stronger than expected payroll number. Even if the data is strong, there will be eager buyers on dips. In tens, 228-230 will likely cap the yield, roughly corresponding with TYZ 126-16, the low just before the Sept FOMC.

The initial target for tens should be around 206, which is the halfway point on the year’s range and seems to have gravitational pull. This level is around 128-24 in futures. Though all fixed income contracts have had big rallies since the Fed meeting, there is likely more to go. For example, red and green Eurodollar contracts this week surpassed their highs from the August 24 stock market swoon, and that’s in spite of the ‘hike this year’ mentality. Absolute levels of back month Eurodollars seem awfully pricey, and calendar spreads are quite tight, however, a continued squeeze to lower yields and a flatter curve at the front end is probable in my opinion, and the trade of most pain.

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Does this look like the Fed’s behind the inflation curve?

Sept 24. Falling knives

–Quiet day in interest rate futures with little net change.  US equities were also nearly unchanged, churning in a tight range.  However, other markets did move.  For example, in emerging market currencies the Brazilian real continues to plunge, ending yesterday at 4.16. (more below).  New low as well in the Indonesian Rupiah and Thai Baht and Canada dollar.  Aussie near new lows this morning.  Industrial commodities are under pressure.  For example Dec Copper settled 229.55, a new low settle for September and closing in on the August 24 low of 220.  The Shanghai steel rebar contract is very near new lows, having fallen 25% since January.  Same with nickel.  Zinc has plunged to a new low, down 32% since the high in May.  Since August 31, Nov Crude has traded a range of 50.04 to 43.89, and was 44.70 late Wednesday, much closer to the low end of the range.  In short, industrial commodities are not providing even a glimmer of hope for stocks.  And it’s not just metals.  New lows in lumber, live cattle, and…Frozen Concentrated Orange Juice.
–At least for stocks, we can always depend on low rates providing ammunition for share buybacks, right?  Not so fast.  Hi yield etfs continue to fall, indicating that credit markets aren’t quite as welcoming as they once were.  After re-opening from a holiday, Japan’s Nikkei fell 2.7% and is near a new low for the move.
–Today’s news includes Chgo Fed National Activity Index expected 24.  Jobless Claims expected 272k and Durables -2.3%.  New Home sales 515k.  Because of the Pope’s visit, apparently these releases may not be exactly on time.  Late in the day Janet Yellen speaks on “Inflation Dynamics and Monetary Policy”.   The problem is, there are no inflation dynamics.   Absolutely no reason to think she is going to modify her dour outlook given the way markets are trading.  As a former treasury economist put it,

”Short-end rates move higher as the Fed gets closer to hiking, and that causes the dollar to strengthen, and that causes global funding stresses. They are creating the conditions that are causing the external environment to be weak, and then they say they can’t hike because of those same conditions that they have created ”

–By the way, here’s a quote from Lockhart yesterday: “Markets should appreciate that the likelihood of substantial spillover to the U.S. domestic economy from developments abroad…is likely to be small.”  Is that what the commodity markets are telling us?  
–Don’t forget there’s a blood moon on Sept 27/28, with associated warnings of the end of days. Bummer.
–The two year note in Brazil local currency yields 16.5% and the currency has done nothing but drop.  If the currency can stabilize, those notes are a huge buy.

Sept 23. It’s deja vu all over again

Sept 22. Of zero rates and caipirinhas

–We’re in a bout of ‘risk-off’ this morning with ESZ -30 (1933…a good year) as of this writing.  New low in Brazil real (3.985).  Other EM currencies also weak, as is copper.
–US yields rose yesterday with considerable emphasis given to Bullard, Lockhart and Williams expressing the need for a rate increase.  Yellen has a difficult task in trying to keep the Fed in line.  Bullard complained about Cramer constantly cheerleading for zero rates, yet his own outspokenness creates communication issues for the Fed.
–Tens ended up 8 bps (at futures settlement) to 220.8, though the selling yesterday has been almost completely reversed this morning.  The curve was steeper with red/gold euro$ pack spread +4 at 133, again, being reversed this morning.  Auctions kick off with today’s 2 year.
–While Bullard got all the attention and rates modestly increased, look at some of the trades that actually occurred:  Buyer of 20k EDH6 9975c for 0.5 (cover).  Buyer of 8k EDU6, Z6 and H7 100c for 1.25 (new).  Seller of 15k EDZ5 9950/9962 strangle with an additional 9937p.  These guys aren’t listening to Bullard, they’re latching onto to Kocherlakota and the negative dots.  “Here’s a good idea: Buy some 100 calls.” Really?  By the way, both 1 and 3 month US bills trade negative as well.  There is some talk about the possibility of a gov’t shutdown at the end of the month, but in 2013, the bill market didn’t really spike up until the middle of October.
–Note once again that high yield etfs HYG and JNK closed lower yesterday in an up market.  As Xi visits the US, there is more talk of bankruptcies in China, with weakness there spilling over internationally (as articulated by several central bank officials recently).  Look no farther than Brazil, mentioned at the top of the note.  The currency has been cut in half in less than two years.  This isn’t Greece, with a $220 billion economy.  It’s ten times larger at $2.3 T.  Almost makes you feel like having a caipirinha.

Sept 21. Euro$ calendar spreads suggest a subdued economy in spite of strong corporate debt growth

–The dollar, even without the benefit of a Fed hike, is firming against other currencies this morning.  Central bank economists at the ECB (Peter Praet) and BoE (Andy Haldane) have warned that weakness in the global economy could spur the need for additional accommodation.  France was downgraded by Moody’s.  In eurodollars, the calendar spreads continue to compress, with EDH6/EDH7 edging to a new 0.5 bps low of 63.5 on Friday.  The peak one year spread is now EDM6/EDM7 at only 64 bps.  One might expect the delay by the Fed to result in higher spreads in the back end of the curve; a ‘less now means more later’ mentality…but the red to green pack spread (2nd to 3rd year) remains stubbornly anchored to around 1/2%, i.e. red/green settled at only 51.875 bps Friday.  In a simplistic sense one could say the market expects only two 25 bp hikes in any give one-year time frame.
–From Wednesday to Friday close, the five year note dropped 18 bps in yield.  The treasury auctions 2’s, 5’s and 7’s so there will likely be a pause for breath.  Activity is likely to be dominated by equity market gyrations.
–The Fed’s Z1 flow of funds quarterly report was issued Friday.  Total credit growth was only 4.4% annualized (respectably at the average of 2014).  In the go-go years of 2006 and 2007 credit growth was 8.4 and 8.1%.  Mortgage debt is finally picking up again with growth of 2.2%, consumer credit was up 8.1% (student debt and autos), while the biggest net change was in corporate debt, up 8.7% to a record outstanding amount of $7.9 trillion.  A sign of confidence by the corporate sector?  Or a sign that corporate buybacks have run their course?  Same questions with bloated business inventories to sales, a sign of increased confidence? Or what Keynes might call, unintended investment?

Sept 20. This is what it sounds like, when doves cry…

This is what it sounds like, when doves cry…

Prince/The Revolution

Prince wasn’t singing about Central Bank Economists, but it’s clearer than ever that they are addicted to monetary drugs to keep asset prices aloft, in an attempt to force forward progress in the global economy, and it’s no longer working.   The equity markets are beginning to see things more like the lyrics in a Pink song…”And I swear you’re just like a pill / Instead of makin’ me better, you keep makin’ me ill”. Well, it worked for a while anyway.

From Reuters Saturday (links below): “Peter Praet chief economist at the ECB “What’s important is to emphasize our readiness and our decisiveness, should the need for action arise”

“That’s premature, at this time, but the risks in the world economy have increased significantly. We have had to correct our economic forecasts downward and we want to be ready to act, should the conditions demand it.”

And from the Guardian Friday: “Interest rates in the UK may have to be cut further from their record low level, the Bank of England’s chief economist has warned, as he highlighted signs that the global financial crisis is entering a third phase of turmoil.”

Andy Haldane cited evidence of a slowdown on the domestic front and risks to the global economy from China, where an economic downturn has coincided with a stock market rout that has sent shockwaves through the world’s markets.

From Janet Yellen’s press conference: “Given the significant economic and financial interconnections between the United States and the rest of the world, the situation bears close watching.”

It’s likely we can thank Kocherlakota for the negative year-end dots for 2015 and 2016. In US markets, we occasionally see trades in ED 100 calls that translate into negative rates, now common in Europe. But the US Federal Reserve, with its sincere communication policy, is opening up this idea to a much wider audience. I don’t know how that can possibly instill economic confidence.

So that’s the ECB, the BoE and the Fed. The doves that study this stuff are clearly worried. Oh, and France was downgraded by Moody’s.

I expected no hike but thought the press conference would provide a strong hint for a near term move. I was wrong. I thought on ‘no hike’ there would be a relief rally in stocks. Correct, for all of about 5 minutes. Global equity markets appear quite vulnerable, with the DAX closing out the week on the lows (new low for September on huge volume, down 3% on Friday).  Japan’s Nikkei was down 2% Friday. SPX closed near the low of the week, and appears to have broken out to the downside of a rising wedge pattern which started with the August low. Again, huge volume. Target 1860.

Despite Friday’s sell off, VIX closed only marginally higher on Friday, and was lower on the week. The real vol smack down occurred in interest rates after the Fed decision. For example the atm TYZ straddle on Wednesday (which was the 126.5 strike) settled at 2’21 or 5.5 vol. On Friday the 128 straddle was 2’08 or 5.1. During the day on Friday TYX straddle was as low as 4.8. According to Bloomberg, 60-day historical is 6.1, a fairly large gap. One interesting note is that in previous cycles there had been consistent BUYING of out of the money calls, but at the end of the week there was a large SELLER of TYX 128 calls in size of about 35k, new position. These calls were sold all the way up from 24/64 to 44/64 Thursday and Friday (settled 0’48); open interest in the strike is 57.5k.

In any case, Friday was the highest settle price for both FVZ5 and TYZ5 since August 24, which was the big stock market sell off day. This week brings auctions of 2’s, 5’s and 7’s, so the front end of the curve may take a bit of a breather after the powerful end of week rally. From Wednesday to Friday close, the five year yield plunged 18 bps, and on Friday FVZ added 69k in open interest.

Despite the run up I would look to buy FV call spreads on any pull back; perhaps there will be a small concession in front of the auction. Having closed at 143.6 in cash fives, with a futures price of 120-035, I think a target of 1.25% yield is attainable over the next month, which is around the 121 strike (121-02). FVX 120.5/121 call spread settled 9/64s and the 120.5/121/121.5 c fly settled 5/64.

Below are net weekly changes in selected markets.

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Links

http://www.reuters.com/article/2015/09/19/us-ecb-economist-idUSKCN0RJ0CW20150919

http://www.theguardian.com/business/2015/sep/18/interest-rates-rise-bank-of-england-chief-economist-andy-haldane

• 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.