FOMC today and the ‘transitory’ effects of lower oil

–From last FOMC statement: “…the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.”  A few points: the decline in energy prices no longer appears transitory.  The dollar is making new highs against many currencies, so import prices are likely to remain pressured.  The labor market already supports a hike.  The inflation picture isn’t doesn’t.  I am including a chart of BAML US High Yield Master II; for the third time since 2013 the effective yield has pierced 7%.  Some credit conditions are already tightening, and likely not just for the energy sector.

–Former Dallas Fed head Richard Fisher was on tv yesterday arguing that the Fed’s job is to focus on domestic concerns, with the implication that the Fed should tighten now and ignore some of the noise in non-US markets.  Maybe he’ll become President Trump’s Treasury Sec’y.  The other Fischer, perhaps the most important member of the Fed, has also argued that the current rate structure is not normal and should be raised.  Yes, rates are too low.  But the world is not normal and there is an overhang of bad debt globally, highlighted by Greece, Puerto Rico, pension obligations.  Feels like we need the forest fire of creditor losses to clear the landscape and allow for new growth down the line.
–So what does the Fed do?  Punt.  Which will likely put some fairly heavy weight on the next two payroll reports.

July 28. Turnaround Tuesday (but only a brief respite)

–There was a decent amount of spillover from the sharp decline in Chinese shares Monday.  The sell off continued in the oil market and EM with new lows in EEM (the emerging mkt ETF), and the hi-yield ETFs JNK and HYG.  Several corporate bond deals were deferred due to turbulent market conditions.  The Russell 2000 (small caps) made a new recent low, closing right on the 200 day moving average, which it hasn’t been below since December.   Treasuries of course, were the beneficiaries of safe haven flows.  Ten year yield fell 4.4 bps to 222.7.  Some eurodollar calendar spreads made new recent lows.  For example, red/green eurodollar pack spread (2nd to 3rd year), fell 1.375 to a new low below 60 bps.  2/10 treasury spread edged to a new low under 158.

–This morning has seen stabilization after five straight days of losses in the SPX.  The FOMC announcement is tomorrow afternoon.  While some indices have held above the recent lows associated with Greece, both the Russell small caps and the Dow Jones Composite are at new lows, with the latter at a new low for 2015.  Any bounce will likely be shallow; perhaps the FOMC will take a step back from its messaging campaign to gradually remove accommodation and spark a brief relief rally.  However, the internals suggest deeper damage.

–I saw a research piece by UBS yesterday suggesting that lackluster capital spending in this recovery might be somewhat misleading, in that some of the capital spending is now actually showing up in consumer spending.  The idea being that relatively small but powerful technologies like cell phones, tablets and laptops are being purchased by smaller businesses with personal credit cards.  While that may be true, there are two related problems.  One, no barrier to entry, which typically means cutthroat competition and lower prices, and two, retail sales haven’t been particularly strong either.  I have heard both Mark Cuban and Marc Andreesen say that the cost of tech start-ups has become very low.  How can that NOT result in severe price competition with disinflationary overtones?

July 27. What happens when gov’t support (or CB accommodation) is yanked?

–Chinese stocks down 8% today.  No surprise, the gov’t stops buying, stocks fall.  What is surprising is that the reaction in US futures is a big yawn (ESU -2.25, as of 5:30 EST).  It’s not as if underlying fundamentals in the US are great.  From FactSet, released July 24: “For Q2 2015, the blended earnings decline is 2.2%.  The last time the index reported a year-over-year decrease in earnings was Q3 2012 (-1.0%).”  http://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_7.24.15  The report goes on to say, “The blended revenue decline for Q2 2015 is -4.0%. If this is the final revenue decline for the quarter, it will mark the first time the index has seen two consecutive quarters of year-over-year revenue declines since Q2 2009 and Q3 2009. It will also mark the largest year over-year decline in revenue since Q3 2009 (-11.5%).”   Friday saw US stock index futures lose about 1%.
–Peak one year calendar spread in eurodollars is EDZ5/EDZ6 but it’s now just 80, down 2.5 on the day (change from Friday).  Once again, the bulk of positioning seems to reflect the idea of a steeper dollar curve.  Beware the crowded trade.
–With the trouncing of energy and other commodities, EM currencies have been savaged.  Yellen will likely try to take a step back from the idea of a near term rate hike.  I would suspect this is going to be a contentious meeting, even without a press conference.
–Today’s news includes Durables, expected to have bounced in June to +3.1 from the previous decline -1.8.  Dallas Fed also released, which unsurprisingly has been in a slide…Texas Tea.
–From BBG: “I see a good chance that the BOJ has to ease more this year, probably in October,” Shinke said. “It’s very clear that the recovery has been much weaker than what the BOJ has predicted so far.”
http://www.bloomberg.com/news/articles/2015-07-26/japan-s-economy-shrank-last-quarter-top-forecaster-shinke-says
–Another case of an over-optimistic central bank, like the Fed, Bank of Canada, Bank of China….

July 26. Weekly summary – It’s not Greece anymore, it’s EM, energy and metals…and debt

THEMES:

• Claims on future cash flows vs physical commodities
• EM in “violent” sell off / hi yield pressured
• FOMC and Staff leak

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Let’s start this week with a chart. Everyone is aware of the commodity price implosion in terms of dollar prices. Here’s a related representation, over a long time period.

Above is the SPX priced in terms of the CRB. It might be a bit difficult to tell from the image above, but the high was 10.7 in February 1999, and the current level is 10.14. Though I have mentioned this before, it again highlights the advances in technology which reduce the need for as much physical material. The paper “Nature Rebounds” by Jesse Ausubel http://phe.rockefeller.edu/docs/Nature_Rebounds.pdf explains this dynamic in tremendous detail, but there is one graphic in the article that captures the concept perfectly. An i-phone is pictured next to some of the much larger things it replaced: a Bell telephone, a video camera, newspapers, photo albums, a big rectangular clock radio with thin metal numbered flaps that rotate to tell you the time and awaken you to the sound of Sonny and Cher singing I Got You Babe. [Groundhog Day, 1993]

The related and larger issue is that of the value of claims on a future stream of earnings (stocks) versus the value of everyday necessary commodities. And the amount to which both claims are underpinned by debt. For example, if your collection of Beanie Babies is bought and paid for, it’s a shame when you wake up one day to realize they’re worth nothing. But if you’ve borrowed to fund your collecting, it’s a disaster.

The metals and crude oil markets are turning into disasters. For example, copper closed this week at 238, the lowest level since late 2009, and has lost nearly half its value from early 2011 when it hit a high of 465. (The low in early 2009 was 125). Gold as well has lost nearly half its value, from nearly $2000 an ounce in 2011 to $1085 this week. Coincidentally, another chart that has been steadily grinding lower since 2011 (actually since late 2009) is shown below.

The chart is China’s Li index, which tracks the annual growth rates in China of outstanding bank loans, electricity production, and rail freight volume. It is a more objective and measurable set of data that reflects the state of China’s economy, giving a more accurate picture than official government data. (thanks JD)

The net effect in the US has been a flattening curve, led by a rally in long bonds. 2/30 fell nearly 11 bps this week to 230 bps. From the beginning of May until now, 5/30 has been in a range of around 133 to 157, having hit the upper end of that range in early July. It closed Friday at 134. The ten year inflation breakeven (Note vs TIP yield) closed at a new recent low Friday of 176, about the midpoint of the year’s range from 154 to 195. Junk bond rates are moving higher, evidenced by new lows for the year in HYG and JNK (high yield ETFs). EM under intense pressure. For example, Brazilian Real lost over 5% this week. http://www.bloomberg.com/news/articles/2015-07-24/emerging-market-currencies-tumble-to-record-low-in-violent-selloff

There was a slight flurry in the market on Friday related to the Fed’s inadvertent leak of staff projections on inflation, rates and growth. As everyone knows, the FOMC dot projections have been wildly different from the market for a long time, though in the past two quarters the Fed has moved its projections much more into alignment. The staff numbers are even closer to the market. In fact, I can just imagine how the fed staff came up with the data:

“Hey Bob, [talking over cubicle wall] …want to call it a day and grab a beer?”

“We can’t Lou, we’re supposed to come up with these economic projections. They were due yesterday.”

“I’m thirsty. Let’s just knock this out in ten minutes. What is the Eurodollar curve projecting? Just take the December contract yields and subtract 10 or 20 bps. And make sure you don’t use round numbers…makes it look like you did more work if you use 1.26 rather than 1.25 for a nominal rate…like you really CRUNCHED the numbers. For our five year inflation forecast let’s just look at the breakeven implied by tips. You can see right there dude, inflation isn’t going above 2% in the next five years. For the ten year treasury yield, just take something close to today and ratchet it up by ½% a year. But not exactly 50 bps…make it 51 in one instance and then 48 in another…like 4 or 5 bps per month. Make it look like you did some exacting work. I’m leaving now. A cold beer will be waiting for you at the bar.”

Let’s just compare the above method to Friday’s prices:

FED STAFF projection Nominal FF rate vs December Euro$ contracts:

2015       0.35%    vs EDZ15 99.455                OR 0.545%           Difference: 19.5 bps

2016       1.26%    vs EDZ16 98.655               OR 1.345%           Difference: 8.5 bps

2017       2.12%    vs EDZ17 98.015                OR 1.985%           Difference: -13.5 bps

Ten year treasury yield: Current 2.27

FED STAFF projection

2015       2.63        Difference 36 bps (from current, or 7 bps a month over the next 5 mos)

2016       3.14        Difference 51 bps (from 2015)

2017       3.62        Difference 48 bps (from 2016)

This week of course, is the FOMC meeting and announcement (Wed). No dots at this one, the above analysis will have to suffice. The market’s not looking for much change. What we know for sure is that whenever the Fed has a chance to really solidify the idea of removing accommodation, they whiff. And in this case, with commodities and EM in freefall, there’s a good reason to take a step back. Janet doesn’t want to be the one blamed for regime change, as EM carnage also fosters political unrest. We also get Durables on Monday, expecting a bounce from the weak -1.8 last time.

In terms of trades, there is a pretty good lean in the market for Eurodollar calendar spreads to stay steady or roll higher. That assumption is starting to look rather shaky. For example, the peak one-year calendar spread on the dollar curve is EDZ5/EDZ6 at just 80 bps, down 2.5 on the week. EDZ6/EDZ7 also fell 2.5 on the week to 64. If there is a large rebound in commodities, or a large sell off in USD, (or both), then the curve will likely bounce off its current support levels. However, it’s hard to imagine a significant reversal of trend in EM or commodities. Even if the Fed were to signal a delay in tightening, the curve may flatten further, and that’s where the real risk comes in, as position unwinds can accentuate the move.

July 24. One US dollar is buying more of EVERYTHING (except AMZN)

–Once again the dollar curve flattened as commodities remain under intense pressure and the USD advances.  [Insert your choice of metal, commodity or currency here…] is making multi year lows.  New low peso.  The Korean Won has been on a one way depreciation since the beginning of May, to a a new low 1164.75. New low Brazilian Real. Copper made multi-year lows just under 238. Gold has cascaded $100/oz just since the end of June.  The currency that has held, pegged in a tight range to the dollar since the middle of March, is the Chinese yuan, perhaps related to bringing credibility to the Asian Infrastructure Investment Bank.  There have been rumors of China selling dollar reserves (treasuries), though it’s not clear from the attached link. http://seekingalpha.com/article/3349915-chinas-holdings-of-u-s-treasuries-without-hyperbole   What is definitely clear is that China’s competitiveness in foreign markets has been chipped away by the decline in other currencies relative to the renminbi.  It would appear, given its economic troubles, as though China has an incentive to depreciate its currency as well…but for now chooses to maintain the façade of economic strength and stability, though China PMI this morning was only 48.2 vs 49.7 expected.  If and when the currency DOES move, it will unleash yet another wave of deflationary pressure over the US.
–Back to US rates… Tens fell another 4.3 bps to 227.7.   All back month eurodollar spreads made new recent lows.  For example, red/gold pack spread fell another 2.125 bps to just 136.5.  Yield curve spreads are at important levels:  2/10 is near a yearly trendline at 157.5 bps; next support should be around 150 (closed 158.3).  5/30 spread has a double top around 155 and is again testing the interceding low of 133.5.  A close below 133 should initially target 120.

–Chicago Fed Nat’l Activity Index was stronger than expected yesterday, as were Jobless Claims.  New Home Sales today.   However, the commodity rout, especially in crude oil, is overwhelming all other data.

July 27. Hellllloooo.

July 21. Value the virtual, not the actual

–No news today…perfect time for turnaround Tuesday.

Weekly summary; Is the Strong USD Tightening for the Fed?

THEMES:

• Curve flatter; Yellen jawbones for a rate hike
• Implied vol imploding like the economy of Greece
• Strong $, Canada in recession, currency wars
• Crude oil indicates global economic fragility
• Tech stocks explode

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The US curve flattened hard this week as Yellen continued to stay the course regarding the prospect for a rate hike for this year. 2/30 yield spread fell 14.3 bps as twos edged to a slightly higher yield (66.5) while bonds plunged 12.7 to 308. The ten year yield fell 6.7 bps to 234.7, gravitating once again to the 50% area (233.5) of the high at the end of 2013, 303, to the low of 164 earlier this year.

The idea of a rate hike also strengthened the dollar with the euro down 3% this week to a new recent low of 108.31. Of course, the IMF calling Greece’s debt unsustainable was another factor for euro weakness, further exposing political cracks. The low in late May was 108.18; year’s low was March 13 at 104.63. As the uncertainty of Greece leaving the euro faded, implied vol was crushed across assets. As an example, consider Green and Blue Sept midcurve straddles. One week ago Friday, 2EU 9812 straddle settled at 32.5 (ref 9810). This week it finished at 26.5 (ref 9812). Same story with the Blue Sept 9762 straddle… from 35.5 to 29.0. I marked the atm USU straddle at 5’32 last week (ref 149-03) or 14% vol. On Friday I marked it at 4’14 (ref 152-03) 11.6%. VIX had the lowest close of the year at 11.95, having been as high as 20 last Thursday.

Crude oil fell $2 bbl to 51.21 (CLU5). For this particular contract, the low of the year was set on March 18 at 49.69, so it’s still about $1.50 away, but the front contract at that time (in March) had a low settle of 44.66. However, I would note that the oil curve was much more contango in March, with the near contract vs one year forward at about a $10 discount, compared to now only 4.60 (CLU5/CLU6). In other words, when oil was first breaking in the beginning of the year, there was a huge incentive to buy the front and sell forward contracts if one had access to storage. Not so much now… Even though there are clear benefits from lower oil, it’s hard not to conclude that soft prices are a reflection of global economic weakness, even if the Iran deal is a contributing factor.

CAD hit a new high 129.75 (a decline in the loonie of over 11% since the beginning of the year) and MXN at a new high 15.93 (peso down around 8%). The Brazilian Real, though not quite at a new low, is down 20% this year. And the dollar index has gone from 90 to 97.90 (up about 8.75%). A research piece from the NY Fed was circulating Friday that said “…a 10% appreciation [of the USD] in one quarter shaves 0.5% off GDP growth over one year and an additional 0.2% in the following year if the strength of the dollar persists.”

http://libertystreeteconomics.newyorkfed.org/2015/07/the-effect-of-the-strong-dollar-on-us-growth.html#.Vaq_0PmZOaU

Regarding Canada specifically, it’s worth mention that the Bank of Canada cut rates to 0.5%, the second of the year after a surprise cut in January. From late 2010 to 2014 the rate was 1%. It had been raised from the rock bottom level of 0.25% which was in place for about a year starting in April 2009. Governor Stephen Poloz cited a disappointing global economy, as earlier forecasts for growth proved over optimistic.

Some say the move is meant to drive down the Canadian dollar to generate more export demand. However, household debt is at nosebleed levels already, with a McKinsey report from earlier in the year noting “Canada’s household debt-to-income ratio rose more than any other country outside of Greece between 2007 and mid-2014…. It hit a record high of 163 per cent in the third quarter of last year. Canada is one of a few countries in the Western world where household debt burdens are higher than they were in the United States at the peak of the global credit bubble…” Note that US household debt to GDP was 98% in 2009, but has declined since then to the current 80%.

Bank of Canada’s Poloz himself expressed concerns about how his latest decision would affect household debt, which is already at very high levels, and the housing market, which many believe is dangerously overheated. “And we must acknowledge that today’s action could exacerbate these vulnerabilities…” http://www.thestar.com/business/2015/07/15/bank-of-canada-cuts-interest-rate.html

Besides Canada, excessive debt is also a huge problem in China: “Corporate China’s debts, at 160 percent of GDP, are twice that of the United States, having sharply deteriorated in the past five years, a Thomson Reuters study of over 1,400 companies shows.” http://www.reuters.com/article/2015/07/19/us-china-debt-companies-idUSKCN0PT00H20150719

The points here are 1) that if there’s any doubt about currency wars, this should quell that idea. 2) Canada is only about 1/10^th the size of the US economy at 1.786T in USD, according to Trading Economics, but it could still have negative ramifications for the US. 3) Because of an election in the fall, there are political overtones, something the US Fed may have to contend with next year.

Canada’s TSX is off about 5% from its high in April, and around where it started the year. In the US, the SPX roared back this week to close near a new high; Nasdaq made a new high. Google alone added about $70 billion in market cap on Friday. The three largest cap stocks in the US are AAPL $746 billion, GOOG $477 and MSFT $378…with FB in the top ten at $267b. Those four tech stocks, with a combined market cap of 1.867T, are valued over 10% of the GDP of the US.

The stronger dollar is disinflationary. It also causes a push into dollar based assets, and may contribute to a reach for yield/ income inequality. Canada had to retreat from its earlier modest hikes.   The Fed wants to lean against financial speculation, and also wants ammo for the inevitable next crisis, but the rest of the world is pursuing easy policies, which makes the US relatively tight. Does Yellen bite the bullet and jack up rates to spur the dislocations that will get the US back to a more normal economic posture? It takes a strong backbone…

“It may be difficult to imagine, but Paul Volcker used to testify before Senate while smoking a large cigar. His physical size – all 6 feet 7 inches – dwarfed the desk he sat behind. He looked as if he was sitting behind a grade school desk! In many cases, the hearings became extremely confrontational, but the giant in the room never backed down, not even for a minute.”

http://blog.rollinsfinancial.com/2008/12/blast-from-past.html

July 17. Curve pounded

July 16. Yellen endorses a rate hike, yields slip

–Once again Yellen said that a rate increase this year would be appropriate, but yields slipped with tens down 5 bps to 235 and fives down 3.7 to 162.3.   This, in spite of higher than expected PPI of +0.3 and +0.8 Core (wholesale egg prices up 84.5% in June).  Industrial Production was also slightly better than forecast.
–There was a large trade early in the day embracing the idea of just one rate hike by year end that would peg 3 month libor to around 50 bps: buyer of 70k EDZ5 9937/9950/9962c fly vs selling 9925p for a one tick debit (max profit at the 9950 strike).  However, the fundamental reasons to justify a move by the Fed appear to be eroding.  For example, late in the day crude was down 158 to just 51.50.  EUR closed on its low of 109.50. (Both look like they will test the year’s lows). Canada cut rates, taking its currency to a new low versus the dollar.  The dollar index closed at its highest level since early June.  Greece erupted in riots (as its current gov’t accepted the deal that even the IMF doesn’t think is sustainable).  And Chicago raised its sales tax to 10.25%.  On top of that, the White House cut its growth forecast to just 2% for this year and projects CPI of just 0.2% for the year.
–Where the market and Yellen appear to be in sync regards the prospect of GRADUAL rate hikes.  The peak one year euro$ calendar spread is March’16/March’17 which is only 80.5 bps, down 3 on the day.  Most one year calendars are around 75 bps, indicating just three rate hikes in any given year.  Option prices are compressing, in line with modest projections on central bank policy.  FVU straddle is again nearing 3% vol, having been around 3.7 a couple of weeks ago.
–News today includes Jobless Claims expected 285k.  Philly Fed expected 12.0 vs 15.2 last.  Also TIC data.

• 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.