Aug 25. One hike by….April?
–Wild intraday swings Monday; final outcome SPX -3.9%, Nasdaq -3.8% and DJIA -3.6%. News sources this morning are mostly finding a positive spin, saying that it’s just because of China, that US growth continues to look stable, that we can shrug it off because it’s not the real economy. I am not saying that’s all wrong, just considering the other side.
–Interest rate markets were more circumspect than stocks. While the VIX exploded, implied vol in treasuries firmed modestly, for example, with the ten year yield down 5 bps to 2.00%, ten yr implied was only up 0.3 to 0.4, closing 6.1 in TYV. Odds of Fed hikes continued to be squeezed out. Near eurodollar calendar spreads made new lows, with peak one year spread of EDH16/EDH17 now only 67.5 ( -1 on the day). Consider April 2016 Fed Funds which settled 99.64, +8.5 on the day. That price indicates just one 25 bp hike, and besides meetings this year there are FOMC dates at the end of Jan and mid-March. So the market as of yesterday’s close only priced 1 hike over five meetings. Sept 17 FOMC just 23 days away…
–The problem, or potential problem, is the damage to confidence in the system. Again the outcome isn’t clear, but back in 2007 I heard many people in the US say they were simply stunned that activity just stopped. Will it happen again? Probably not. (GDP Now from Atl Fed is tracking just 1.3% for Q3). In terms of China, issues that were just below the surface have now bubbled up, or literally exploded, as the case may be. I would personally bet that the response will be to step up military activities in the South Sea, and to continue to provoke neighbors, for example by drilling in waters claimed by Vietnam, so that an actual fight develops, to spur national pride and shift the mood away from economic issues. It’s a longer term scenario, but one that will likely expose political paralysis in the US.
August 24. Change in the trend of risk
–On Friday, all near eurodollar calendar spreads made new lows as stocks tumbled and the Fed quietly exited through the side door. With global carnage continuing early Monday, the prospect of a Fed hike this year is evaporating. The peak one year calendar spread is March’16/March’17, now only 68.5, down 4 on Friday’s session and probably headed for the mid-fifties. Red/green pack spread is just 54.375, a slight new low.
–Some of Friday’s stock market selling was associated with August option expiration, but the global nature of weakness in both equities and commodities makes it feel much less technical in nature and more like a change in trend. Last year’s mid-October plunge was reversed within a few weeks. While we’ll likely see a bounce sometime this week, it will serve as a selling opportunity. The increase in corporate bond spreads foretold a change in risk appetite and it’s not over yet.
–During late June when the markets were fixated on the possibility of grexit implied vol in TY jumped to 6.2. Greece is a small issue when considered against a collapse in Asia, yet ten year vol only went to about 5.6 last week, even as VIX soared to 28. Probably not bad to own some insurance in the form of option premium, either in treasuries or back midcurves.
August 23, 2015. Financial Stability vs Inflation – weekly summary
THEMES:
- Last week’s note: The Price of Risk
- Trend changes?
- A Fed on hold leads to weaker dollar/steeper curve
- Seven year cycle
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Here’s an excerpt from last week’s note:
Without QE the market is forced to actually put a realistic price on risk.
Therefore I think stocks are likely to see selling pressure with risks of a sharp break. I think the Fed will continue to talk tough, but will not be able to pull the trigger at September’s meeting. Asymmetric risks will stay the Fed’s hand.
Given my world view, I like buying 2 year notes, current yield nearly 73 bps. I think 5/30 will rebound a bit when it becomes apparent the Fed won’t hike. Currently 125, strong support at the 61.8 retrace which is 122. Stop below 115. I like buying EDH7/EDH8 48-50, now 54.
So those were pretty good ideas, though EDH7/EDH8 never hit target; closed 51.5. 5/30 closed at 131.
What’s interesting about this week is although the SPX fell 5.7%, treasury yields didn’t change all that much, especially on Friday, which encompassed 3.2% of that drop. Fives had the biggest drop on the week of nearly 16 bps, as views on the prospect of Fed tightening were scaled back. The two year note fell 10 bps to 62.5. The ten year yield is holding right around the 50% retrace of the year’s low to hi (164.2 to 248.5) at 206…ended Friday at 205. Going forward it will likely range between 195/196 to 220.
To my way of thinking, there are now three major considerations for the market. First, has the equity market changed trend? I believe that it has, and that it will be unlikely to make a new high from here for a substantial amount of time. Second, will the US Federal Reserve begin a tightening cycle? While I do think there’s a chance the Fed will actually change the FF target, I don’t believe it will be construed as a true change in terms of a tightening cycle and change in institutional bias. Third, will the dollar index change trend? I think there is a possibility of a change in trend in the dollar; the door is open on that theme; so far DXY holds the 200 day moving average.
Of course, this week it wouldn’t be a surprise to see a stock rally. Apparently some selling this week was associated with August option expiration on Friday. There will be some bottom fishers. The big issue is whether the trend has changed. If it has, it’s important because of the psychology of the wealth effect, and possibility of more modest consumption going forward. AAPL alone has lost just under 20% in the past month, nearly $150 billion in market cap. That’s a lot of wealth… evaporated.
I saw a very interesting interview this week on BBG (thanks WHM) with Stephen Roach on August 20. He said the trade-off for the Fed is between inflation and financial stability. That is a huge point, and it appeared to me as if Roach was somewhat exasperated that it flew past the Bloomberg panelists unnoticed, like a couple of bats zigzagging through the sky at dusk.
I agree with what I believe to be Roach’s point: the key isn’t the labor market, if that were the case the Fed could have tightened long ago. The problem is one of the Fed’s own making, that of low rates and official encouragement (bribery) for the ‘investing’ community to pour into higher risk assets with newfound liquidity, which caused a mispricing of risk. And now the risk genie is coming out of the bottle. If the Fed wants to make sure the market understands it has changed its tune on excessive risk taking, it will hike. If the Fed just looks at inflation, it must stand down.
I’ve heard precious little lately about ‘macroprudential tools’ that the Fed was going to employ to make sure excessive risk didn’t destabilize the economy. On the other hand, we have companies like MetLife pulling a Bruce Jenner and saying it’s NOT an American company, in order to bypass Dodd-Frank. Now the question is whether the Fed has the fortitude to tighten/normalize even in the face of a risk-off period. It’s pretty obvious to everyone that inflation is not on the verge of a surge, though we all know at some point the price of oil will stop going down and yoy comparisons will show up in inflationary data. I believe the market knows the price of risk was too small, and I further believe that the increases we’re beginning to see are healthy over the long haul. However, as an institution, the Fed likely doesn’t have the courage to tighten and stamp an official imprimatur on a book which shows its views on excessive risk taking have changed.
What does it mean in terms of trading? A Fed on hold means the curve could begin to steepen from reds back. However, Fischer’s Jackson Hole speech on Saturday August 29 will be quite important to reveal the Fed’s thinking. We are at or near attractive long term buying levels, for example, on reds to blues, which closed at 93.375 bps as a pack spread. Aggressive target of 140 to 150 by the end of the year.
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This next section is a bit off the beaten track, and concerns a seven year cycle referenced in the Bible as the Shemitah, which happens to be about relinquishing debts. (And a WSJ article notes that 17% of college loan debt is severely delinquent). I’m not much one for linking religious theories with broad market themes, however, the seven year pattern in the autumn seems to have something going for it. As Dr Ray Stantz tells Winston Zeddemore in Ghostbusters: “Every ancient religion has its own myth about the end of the world.”
However, over recent history this seven year itch, and I’m not talking about the Ashley Madison kind, has a pretty good track record. Let’s start with October 16, 1973. OPEC raised oil prices by 70% and sparked a nasty recession in the US. In 1980, US inflation hit its peak of 13.5% and the Fed under Volcker raised Fed Funds to 12% in September, eventually getting to 20% by the end of the year…recession. In 1987, on Oct 17, then Treasury Secretary James Baker threatened to devalue the dollar and on Oct 19, Black Monday, stocks crashed 22%. In 1994, the bond market crashed, and on Dec 20, Mexico devalued the peso…the Tequila crisis. In 2001 we had another stock crash and 9/11. On Sept 17th 2001 the Dow lost 684 points. In 2008 on Sept 29, the Dow lost 777 points or 7%. And…here we are in 2015, with the Shemitah on Sept 13, which coincides with a solar eclipse. Whether one looks at Elliott waves or Kondratieff cycles or frames history according to the Fourth Turning (Strauss and Howe), we seem to have a lot of issues currently which fit with warning timeframes.
I am not going to add links for the Shemitah stuff, you end up at a lot of fringe sites. But in terms of other cycle theories, here are a couple of links. Carpe diem.
“So will the period of 2015 to 2020 turn out to be pure hell for the United States?” http://michaelsnyder.mensnewsdaily.com/2014/05/if-economic-cycle-theorists-are-correct-2015-to-2020-will-be-pure-hell-for-the-united-states/
“On this interpretation, the big meltdown doesn’t begin until 2018-2020”
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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. Trading advice is based on information taken from trades and statistical services and other sources that R.J. O’Brien believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. Copyright 2015. Alex Manzara
August 21. “Funny how?”
–Global stock markets the world over tumbled as one of the world’s keenest financial strategists, Alexis Tsipras, resigned. Well, maybe it wasn’t exactly for that reason, but US indices fell over 2%, as weak equity market action dominated yesterday’s trade. With China’s dismal Caixin/Markit Mfg PMI of just 47.1, the lowest since 2009, ESU fell another 20 handles last night but has come back to slightly positive as of this writing. Funny, but a lot of markets are getting to levels not seen since bottoms in the heart of the crisis in 2009. (“Funny how?) Perhaps the dislocations that led up to the “great recession” were never really resolved but simply misplaced, and are percolating up here and there once again.
–New lows again in many EM currencies. Dow Jones Composite made a new low for the year, unlike SPX and Nasdaq. The ten year yield fell 4.6 bps yesterday to 208, again gravitating to halfway back of the year’s range, from 164 in January to 248.5 in June. Overall activity in interest rates was subdued with implied vol essentially unchanged (though higher in USU). On previous bouts of financial angst ten year vol had jumped up to 6.3 or so, now mired at 5.4. VIX, on the other hand, leapt 3.9 yesterday to 19.14.
–The curve flattened with a new low in red/green euro$ pack spread to 54.5, -1.5 on the day. 2/10 treasury spread also made a new low of 141, plunging 6.3 on the day. Junk spreads are making new highs. Interesting to note that HYG and JNK (hi yld etfs) are at new lows, and testing levels last seen in late 2011, though no where near the 2009 carnage.
–September treasury options expire today, along with August equity options.
August 20. Even the Fed’s starting to notice…
–From the FOMC minutes: “Some participants also discussed the risk that a possible divergence in interest rates in the United States and abroad might lead to further appreciation of the dollar, extending the downward pressure on commodity prices and the weakness in net exports.”
–The clues are piling up so fast that even some participants at the Fed are starting to notice. Crude oil was again crushed yesterday and this morning is threatening to break into the 30’s (CLV 40.60, -67). Junk bond spreads continue to widen. An index of Investment Grade Credit Default Swaps is breaking out to the upside, mirroring corp bond spreads in general (thanks RR). The plunge in commodities knocked 10% off the value of Glencore in one day (after poor earnings). Emerging market currencies continue to make new lows on a daily basis, punctuated by a 27% plunge in Kazakh’s tenge, which abandoned its peg. Even US stocks are beginning to look wobbly, which would weaken one of the famous pillars of the US recovery, the ‘wealth effect’. “Market based indicators of future inflation” like the spread between 10 year treasury and tip yield made a new low yesterday of just 158 bps. And yes, cats sleeping with dogs.
–So, the odds of a September rate hike diminished as reflected by futures pricing. New lows were made in all near eurodollar futures calendars. For example, the peak one year spread, Dec’15/Dec’16 fell 4 bps to break decisively through support at 75, settling at just 72 bps. There isn’t a three month spread above 20 bps, in a supposed tightening environment. Some say the Fed will still hike in Sept, just to maintain credibility. There was a time when the central bank stood up to the market. That time is not now.
–Somewhat surprising that implied vol in treasuries was steady on yesterday’s push to lower yields and higher strikes. Sept options expire Friday. TYU settled 128-03, heaviest call Open int 128 and 129 at 67k and 72k. The 127p has 78k open, up 19k yesterday on new buying.
–Plenty of economic data today, which is likely meaningless. Jobless Claims 270k (can’t get much lower). Philly Fed 7.5. Existing Home Sales 5.4m and Leading Economic Indicators +0.2.
August 19. A hard rain’s a-gonna fall
–Tuesday again featured new lows in copper, though oil staged a modest bounce. US yields bounced as well, with tens erasing Monday’s rally and ending up at Friday’s close of 219.6, up 4.8 on the day. Volume was sparse. Though oil was up, both RBOB gas and natgas closed lower on the day. Late comments by Gundlach… says copper and commodity price drops reflect global economic weakness, and ‘China should be a huge concern, it is the second biggest economy in the world.’
–Today’s US news includes CPI, expected +0.2 both headline and core, and FOMC minutes from July in the afternoon. Though the minutes could read somewhat bearishly, the month of July featured hard sell offs in oil and emerging mkt currencies and increased spreads on junk. These factors are almost certain to factor prominently in the discussion.
–In terms of China, the news just keeps getting worse. There’s a piece on ZeroHedge today (link below) that a spate of defaults looms in wealth mgmt products (WMPs). In terms of size, it seems as though the gov’t can easily backstop any problems. However, it has a familiar echo to the start of the US crisis, where early signs included problems in SIVs (Structured Investment Vehicles). From an article almost exactly 8 years ago (8/12/2007) in the Financial Times: “In a corner of the market few people knew existed, regulators are scrambling to understand what is happening in structured investment vehicles (SIVs), a breed of often huge, mainly bank-run, programmes designed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments.”
–While the financial problems are challenging, a friend of mine who has spent a lot of time in China is a lot more concerned about the possibility of “serious civil unrest”. He notes that there have been other factory explosions and industrial accidents aside from Tianjin that have never made the news. Also, the reason Tianjin is so scary is because of sodium cyanide at the factory and the problems caused by its reaction with water (rain). From the Center for Disease Control website, “Sodium cyanide releases hydrogen cyanide gas, a highly toxic chemical asphyxiant that interferes with the body’s ability to use oxygen. Exposure to sodium cyanide can be rapidly fatal.” Want to take your mind off the market? Skim this:
http://www.cdc.gov/niosh/ershdb/emergencyresponsecard_29750036.html
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I’m a-goin’ back out ’fore the rain starts a-fallin’
I’ll walk to the depths of the deepest black forest
Where the people are many and their hands are all empty
Where the pellets of poison are flooding their waters
Where the home in the valley meets the damp dirty prison
Where the executioner’s face is always well hidden
Where hunger is ugly, where souls are forgotten
Where black is the color, where none is the number
And I’ll tell it and think it and speak it and breathe it
And reflect it from the mountain so all souls can see it
Then I’ll stand on the ocean until I start sinkin’
But I’ll know my song well before I start singin’
And it’s a hard, it’s a hard, it’s a hard, it’s a hard
It’s a hard rain’s a-gonna fall
–Bob Dylan
other links:
http://www.ft.com/intl/cms/s/0/8eebf016-48fd-11dc-b326-0000779fd2ac.html#axzz3jFidpnFk
August 18. Recession in 2016?
–Monday featured consistent buying in the front end of the curve. EDZ5 open interest gained 22k and EDZ6 was up 10k according to prelim open interest data. Ten year yield fell 4.6 bps to 214.8. New lows posted in several measures of the curve. For example red/green euro$ pack spread closed at 55.75 and red/blue closed at a new recent low of just 94 bps, -2.375 on the day. This, despite a solid rally in stocks off early weakness (though volume was light). 2/10 treasury spread was down 2.6 bps to new low 144.2. According to a piece on Business Insider, Goldman’s clients are asking a “surprising” question, about the possibility of recession in 2016. The mere fact that the question comes up is worrisome. However, the article points out that with a positively sloped yield curve, the odds are likely small. I would simply argue that it’s hard for the curve to go inverted with front end rates already so low, but the very fact that front end rates ARE so low after seven years gives a pretty good clue as to the strength of final demand.
–China stocks down 6%. Copper at new 6 year lows. Crude oil is becoming comfortable in the 41 handle. I don’t watch energy stocks all that closely, but Chevron (CVX) gapped lower to settle at a new low yesterday. Noble Energy (NBL) has been cut in half in a year.
–EM currencies make new lows every day. Yesterday some new lows were Turkish Lira, Malaysian Ringgit, Indian Rupee and SA Rand.
–Housing Starts today, expected 1.18 million. By the way, lumber is also near new yearly lows.
August 17. The price of risk
THEMES:
- Painful trends continue, stocks are the notable exception
- Corporate bond spreads widening
- Rolling devaluations, punctuated by China this week
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Here’s what we know, and it’s all been exhaustively covered in the financial press and blogs:
- Oil closed at a new low for the year and shows no sign of a bounce
- Commodities in general are getting crushed. BBG Commodity Index at a level not seen since 2001
- Credit spreads are blowing out. Hi yield ETFs HYG and JNK are at new lows for the year
- The curve has flattened hard in the past month, with 5/30 sub 125, 30 bps below July’s high
- EM currencies are getting hammered
- China devalued, no longer willing to cede export share to other countries that have devalued either thru QE or other monetary policies, with deflationary implications
It’s amazing that net changes in treasury yields were extremely small on the week.
Rather than include a bunch of charts to review things that we all pretty much know, I will just show this BAML BBB Corporate bond spread (below) and add a couple of interesting links. By the way, a BAML study cited on ZH notes that the difference between the high yield spread and the third VIX contract is at the highest level since just before Bear Stearns blew up…i.e. the stock market is complacent.
The above spread is up 40 bps from the year’s low, and 75 bps from last year’s low. Hi-yield spreads have, of course, blown out even more.
Bloomberg piece about credit. “Credit is the warning signal that everyone’s been looking for” said Jim Bianco, founder of Bianco Research LLC in Chicago. “That is something that’s been a very good leading indicator for the past 15 years.” Another quote, “All of this has corporate-bond investors concerned enough that they’re demanding 1.64 percentage points above benchmark government rates to own investment-grade notes, the highest since July 2013, Bank of America Merrill Lynch index data show.”
And here’s a good piece on China from the Telegraph’s Ambrose Evans Pritchard: “Few dispute that China is in trouble. Credit has been stretched to the limit and beyond. The jump in debt from 120pc to 260pc of GDP in seven years is unprecedented in any major economy in modern times.” Concluding: “One day China will pull the lever and nothing will happen. We are not there yet.” http://www.telegraph.co.uk/finance/economics/11799504/China-cannot-risk-the-global-chaos-of-currency-devaluation.html
Now we’ve gotten to the point where there is a lot of micro-analysis going on. Like the idea that a 10% rise in the trade weighted dollar reduces GDP by 50-100 bps after two years. Or that a 1% move in EM causes a 1% move in US GDP. I have seen several estimates based on the dollar and on commodities that attempt to QUANTIFY cause and effect. The problem is that there are many changing variables, occurring simultaneously. So…”the model WOULD have been right, if not for the oil collapse which caused cascading bankruptcies…”
Here is how I see it. The plunge in oil and other commodities reflects a drop in global demand, which is also evident by the fall in global trade. The bond market sees the idea of Fed tightening as a policy mistake, causing dollar strength and flattening the curve. China is falling under its own weight, and its response is acceleration in overt state intervention, most recently by depreciating the yuan. We’ve had a series of rolling devaluations, starting with US QE, followed by Japan, which took JPY from 80 to 125, followed by the ECB which took EUR from around 140 to 110. Now it’s China’s turn. Because of bloated debt levels, the net positive effect declines with every new policy implementation, no matter where it occurs geographically.
At the same time, the US, with a lag, is feeling the effects of the end of QE3. Outright purchases ended in October 2014. The purpose of QE is to hold down longer term treasury yields and force investors into riskier assets so that companies can take advantage of lower borrowing rates to build up capital infrastructure and expand. You can see by the BBB bond chart above that the nadir in the spread was in 2014 just prior to the end of QE3. We also know that a lot of this cheap funding went into stock buybacks, in order to juice earnings per share. I don’t know how to quantify the amount of lag in monetary policy. I don’t know how to quantify the impact of dollar strength, or oil weakness. What I do know is that the window for financial engineering is closing, and that companies are still trying to lock in cheap funding, and that corporate debt in absolute dollars is at an all-time high. (From Fed’s Z.1 report). Without QE the market is forced to actually put a realistic price on risk.
Therefore I think stocks are likely to see selling pressure with risks of a sharp break. I think the Fed will continue to talk tough, but will not be able to pull the trigger at September’s meeting. Asymmetric risks will stay the Fed’s hand.
Current low volatility belies strains on the global financial system, in my opinion. We have a fairly light news week, with CPI and FOMC minutes Wednesday and Philly Fed Thursday. No matter what else occurs, the price of risk is likely to firm.
Aug 14. The global markets have already tightened for the Fed
–Eurozone Q2 GDP was slightly lower than expected at 0.3. The Atlanta Fed GDP now model dropped its forecast for Q3 from 0.9 to 0.7, mostly on a technical adjustment. But it’s not being dropped 0.2 from 2.5 to 2.3….the number is still sub 1%. Of course, last time it started low and moved higher as data came in…this time could be the same.
–News today includes PPI expected 0.1 both headline and core. Industrial Production expected +0.3, with Capacity at 78.0. By the way, capacity utilization has been drifting down all year, it was 79 early this year. Michigan Sentiment expected 93.5 from 93.1.
Fed going to tighten given inflation expectations? Oxi
In this morning’s note I mentioned the spread between ten yr treasury and inflation index yield. Other people are also talking about this. Lower graph is the spread, near new lows. Below is the 5y, five year forward inflation swap….same idea. Lower inflation expectations.
