Sept 27. Fed’s Stein suspects other investors have influence on bond yields; more research needed. :- l

–Relatively quiet yesterday as yields backed up slightly after the recent rally.  Auctions concluded with a somewhat soft 7 yr, but the ten year yield only rose 2.7 on the day to 2.64.  Implied vol was better bid, perhaps not surprising given congressional shenanigans related to a shutdown.
–Yesterday’s GDP Price change was +0.6, the lowest since the depths of the crisis.  Today Personal Income and Spending expected +0.4 and +0.3, but also, and more importantly, Core PCE prices expected +0.1.  The Fed uses Core PCE as a preferred measure of inflation, and of course has a dual mandate with respect to inflation and employment.
–Fed’s Stein gave an interesting speech yesterday, which in my opinion was all about the difficulty of removing QE. He theorizes that a “recruitment channel” that induces bond investors to reach for yield was in large measure responsible for the change in rates to the downside, and subsequently to the upside.  To which I say, “Duh”.  From Stein: “If the Fed’s control of long term rates depends in substantial part on the induced buying and selling behavior of other investors, our grip on the steering wheel is not as tight as it otherwise might be.”  (Surprisingly enough, some people have a problem with career academics running Fed policy).  He also says this, and it’s likely true and important: tighter financial conditions have “brought term premiums closer into line with historical norms, and thereby arguably reduced the risk of a more damaging upward spike at some future date.”  The point is that these other investors have partially unwound their “reach for yield” but the Fed has no real way to control their (volatile) behavior.  So he concludes that a strictly mechanical rule be put in place, for example tying the pace of QE to the unemployment rate.  This line of thought, tying monetary policy more mechanically with specific economic data such as employment and inflation, is gaining credence with all central banks. Interestingly, the Indian Central Bank head (who Stein mentions in his speech), is shifting to CPI as his guide for changes in monetary policy.  Strange dichotomy that in the US, with PCE prices well below target, that employment is more of a guide, while in India, a currency crisis is making inflation fighting a top priority.  But both want more “mechanical” decision making.  What if you choose the WRONG data to tie policy to?  What if that data is flawed? (For example labor participation rate skewing unemployment rate or Core PCE not capturing the inflation viscerally felt by US households).

Sept 26. Fed’s Flow of Funds report shows deceleration of credit growth

–Once again all one year calendar spreads in dollars went to new recent lows. For example, EDU5/U6 settled 102.5, down 2.5 on day, just below the spike low after FOMC. However, while near contracts have recaptured nearly all of the sell off since May, deferred contracts haven’t.  For example, EDU17 hasn’t even come back to a 38% retracement yet.  So, forward guidance has convinced the near part of the curve that nothing is going to happen.  But the back end is going to be much more data dependent.
–Ten year note yield fell nearly 4 to 2.613.  From May low yield of 1.62 to the high of nearly 3% in early Sept, the 38% retrace is 2.47, which I think is a reasonable objective.
–Walmart is apparently cutting new orders because inventory of unsold items is piling up.  Also, Fed’s Flow of Funds report came out yesterday.  I haven’t gone through it carefully (most news reports will tout the new high in household net worth, though apparently that has something to do with a change in pension calculations: ZH).  What I would note is that mortgage debt declined in Q2, for the 17th straight quarter.  Consumer Credit has decelerated for the past 2 qtrs. Business debt growth is reasonably strong (+6.9 in Q2, and the FT says US corporate bond issuance is set for a record in Sept) but Fedl Govt debt went from +10.1 Q1 to +2.5 Q2.  Without credit growth, the economy stagnates.  Period.  On that note consider this snippet from BBG regarding Europe: “Loans to the private sector dropped 2 percent from a year earlier, the Frankfurt-based European Central Bank said today. That’s 16th monthly decline and the biggest since the start of the single currency in 1999.”  There is no way Europe is “fixed” if loans to the private sector are falling.
–EDZ4 settled 9947…getting ever closer to the 9950 strike which has 477k open positions in calls.  Delta around 40…the EDZ4 contract has only 776k open interest.
–News today includes Q2 GDP revision, expected +2.7. Job Claims expected 330k. Seven yr auction.

Alex Manzara

relevant links:
http://www.zerohedge.com/news/2013-09-25/rejoice-america-you-are-now-3-trillion-wealthier-due-definition-change
http://www.federalreserve.gov/releases/z1/Current/z1r-2.pdf
http://www.bloomberg.com/news/2013-09-26/ecb-says-private-sector-loans-fell-for-a-16th-month.html

Fed policy in the rearview mirror. Revisiting Bullard’s ‘Seven Faces of the Peril’

St Louis Fed President wrote ‘Seven Faces of “The Peril”’ three years ago in 2010.  The peril he describes is an undesirable “steady state” with rates near the zero lower bound combined with low to negative inflation.   “This new long run outcome can involve deflation and a very low level of nominal interest rates.  Worse, there is presently an important economy that appears to be stuck in exactly this situation: Japan.”  Clearly, the concern that this paper was meant to address was the risk that the US could fall into just such a quagmire.  It’s close.  Here we are three years later with low nominal rates, Core PCE price change of only 1.2%, and subpar growth.

http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf

“In his criticism of the approaches and support of Keynesians to economic policy, [Milton] Friedman distinguished between three forms of lags which appeared in economic policy: the observation lag, the decision lag and the effect lag. He argued that these lags had major destabilizing effects and the challenge should be to simplify monetary policy to achieve stable growth in supply.” http://www.bized.co.uk/notes/2013/06/milton-friedman-and-his-contribution-economics

Not only do we currently have lags, it’s becoming increasingly murky as to what the policy decision should be.  In any case, one of the problems Bullard identifies with the “unintended steady state” is that monetary policy becomes passive.  He says that “…pledging to keep the policy rate near zero for such a long time would be consistent  with the low nominal interest rate steady state in which inflation does not return to target but instead both actual and expected inflation turn negative and remain there.” To this point, I would say that the last FOMC non-taper decision further cemented expectations of low inflation.

In his paper Bullard outlines the seven arguments that address the problem of steady state low nominal rates and low to negative inflation.  Topics that are not mentioned, and which very likely reinforce the peril are 1) huge debt levels relative to GDP 2) huge unfunded pension liabilities and 3) demographics that accentuate medical and retirement costs.

He concludes “that promises to keep the policy rate near zero may be increasing the risk of falling into the unintended steady state….and that an appropriate quantitative easing policy offers the best hope for avoiding such an outcome.”

Yesterday, NY Fed chief Dudley said that policy under Yellen would be the same as in the past.  I don’t agree with Obama on much, but in some sense I understand his frustration when he said of Bernanke, “He’s already stayed a lot longer than he wanted or he was supposed to.”  Fed policies appear stale with regard to improving underlying economic fundamentals. Perhaps Obama was (finally) right about pushing for a change in tack at the Fed and not wanting a career bureaucrat like Yellen at the helm.  But he misplayed that hand.   

Keep in mind that Japan has now embarked on several of the ideas in Bullard’s paper…including massive QE.  Yet, JGB yield is only 66 bps today.  It’s not clear that inflation/growth have hit escape velocity.  One of the seven ideas to combat the steady state is as follows… “The gov’t threatens to behave unreasonably if the private sector holds expectations (such as expectations of very low inflation) that the gov’t does not desire.  This threat, if it is credible, eliminates the undesirable equilibrium.”  Here again, Japan has tried that strategy without success.  In the US on the other hand, it can be argued that the gov’t has been completely credible in behaving unreasonably and irresponsibly, but in a way that more likely solidifies the unintended steady state.

Bullard writes, (again, from 2010), “During the recovery, the US economy is susceptible to negative shocks which may dampen inflation expectations.  This could possibly push the economy into an unintended, low nominal interest rate steady state.  Escape from such an outcome is problematic.”

It is now three years later.  As Bullard suggested, the commitment to low rates hasn’t helped the US economy escape.  However, neither has QE, though it has surely been a benefit at the margin.  And even massive QE as being undertaken by Japan doesn’t seem to be doing the trick in an environment of aging population, and massive overhang of debt.  In fact, it seems that the servicing of debt and other obligations related to previous malinvestment, both by the private sector and by the public sector in terms of unsustainable pensions, etc, might be the biggest factor in terms of restraining the economy.

So, the question is, will the ‘new’ Fed try bolder experiments to shake the economy up?  Will the Reverse Repo Facility figure into that plan (if there is one)?   There is almost always a trial by fire for the new Fed Chair, and this time will be no different, even if current policies remain in place.  Let’s hope it doesn’t resemble the scene in Hitchcock’s North by Northwest where Roger Thornhill (Cary Grant)  completely disrupts the auction process.

http://www.youtube.com/watch?v=4bdfenrWYTs

Sept 25. Bonds continue to rebound…

–All one-yr euro$ calendar spreads made new recent lows as yields fell across the board.  EDU15/U16 closed at 105, down 4 on the day. (This and EDZ5/Z6 are the highest points on the curve).  It had spiked as low as 103 on FOMC day.  Ten year yield fell over 6 bps to 265.  Red/gold euro$ pack spread fell nearly 11 bps to 274.  EDZ15/EDZ17 spread was sold 50k yesterday, settled 7 bps lower at 196.
–Note on ZeroHedge warns that employment data (one week from Friday) could be delayed due to a gov’t shutdown.
–From CNSnews: Revenues from state and local individual income taxes, general sales and gross receipt taxes, motor fuel taxes, motor vehicle taxes and taxes on alcoholic beverages each hit all-time highs in the second quarter of this year, according to data released today by the Census Bureau.  I suppose that could be construed as good news if the economy were booming, but likely it’s due to higher tax rates…siphoning money away from consumption?
–News today includes Durables expected -0.5 from last month’s very weak -7.3.  New Home Sales for August expected 425k.  Five year note auction.
–The very front of the curve was just a touch weak going into the end of the session yesterday.  I would attribute that to pressure associated with long calendar spread exits and somewhat soft two year auction.  Libor setting has been grinding lower for the past couple of months.
–From Dallas Fed head Fisher yesterday, quoting his disagreement with the non-taper decision, “Doing nothing at this meeting would increase uncertainty about the future conduct of policy and call the credibility of our communications into question.” I believe that is exactly what has occurred, though I take no pleasure in saying so.

Sept 24. Risk markets erase FOMC gains while bonds test highs from last week

–Interest rate futures rose yesterday as Draghi pledged low rates for a long time and Dudley said the Fed must act forcefully to push against economic headwinds, including fiscal uncertainties.  Ten year yield ended 2 bps lower at 2.71.  Near one-year euro$ calendar spreads fell to new recent lows, for example EDM14/M15 closed below 1/2% at 48.5 bps, down 2 on the day.
–Broad stock index futures (ESZ, DJIA) have given back all gains from the Fed’s “no taper” decision, as has crude oil.  Copper and gold are also pressing lower, nearing levels seen just before the Fed.  However, treasuries are close to the spike high made just after the FOMC, in spite of this week’s auctions which kick off with 2s today.  Other news includes Consumer Confidence, expected 80 from 81.5 and Richmond Fed, 10.5 from 14.0 last.  From these lofty levels, it might be hard for stocks to boost “wealth effect” benefits, even if the Fed maintains QE buying.
–Red/green euro$ pack spread closed yesterday just above 96 bps, holding close to 100 as Fed projections and gen’l market sentiment indicate rate increases in 2016.  In April, just prior to Fed hints of lowered accommodation, red/green pack spread averaged 31 bps over the month. So the spread is now over 3x higher.  Perhaps greens are still relatively cheap?  I would guess that the seller of Green Oct 9825/9837/9850 c tree (sold 2 legs flat) on Sunday eve after Summers withdrew might now have a different feeling about EDZ15 upside, as it trades 9870.
–Debt ceiling and Obamacare likely to dominate news this week…probably not good for general confidence.

Sept 20. Market continues to digest Fed’s inaction….

–Adjustments continued in the fixed income arena in the wake of the Fed’s decision to stand pat. After a large flattening of the euro$ curve immediately after the Fed, a stealth steepening crept back into the market yesterday, in part a reaction to strong data (Philly Fed soared to 22.3).  For example, late Wed the EDU15/EDU16 spread traded 103, having settled at 118.5 Tuesday and reached a high for all one-yr spreads of 122.5 in late Aug.  Yesterday it edged back up to 109.5.  Currently, the peak one year spread is EDZ15/Z16 which closed yesterday at 111.5. While calendar spreads edged back up, implied vol was hammered.  Long dated red and green straddles fell 3.5-4.5 bps.  For example EDM5 9912^ was 71.0 Wed, but 67.0 yesterday.  EDM6 9812^ 130.5 to 126.0.
–Not much in the way of economic news today but there are several Fed speakers including George, Kocherlakota and Bullard (12:55 NY time).
–The dollar continued to weaken with a new high in EUR and dollar index making a new low, but emerging currencies continued to recover, lessening EM crisis risk.  India surprise hike of 25 bps today to 7.5%.
–Immediate risk to the market concerns the debt ceiling fight but perhaps Obamacare is also a headwind as more companies announce plans to change employee healthcare status (Home Depot today, adding to Walgreens, Trader Joes, etc).  My guess is that such announcements, even though they may not affect huge amounts of the labor force, have a restraining influence on consumption plans as healthcare is something like 17% of GDP.
–13 people were shot last night in Chicago.   While pensions and employee health care costs are regularly cited as the reason for municipal deficits, part of what caused Detroit’s demise was flight from violence.  If you want to read something a lot more compelling than Fed speeches today, here’s a fascinating article (thanks Slayer) http://www.bloomberg.com/news/2013-09-17/heroin-pushed-on-chicago-by-cartel-fueling-gang-murders.html

Sept 19. To paraphrase Al Haig, BB: I’m in charge here…

–I can’t help thinking of the old beer commercials… I can see Bernanke lifting his stein in a mock toast, “Here’s to you Mister I’ll sell short Dec strangles and buy blue put spreads…”

When the Fed indicated they wanted to “push back” against perceptions of tightening, they weren’t kidding.  Lack of taper caught the market by surprise. All near eurodollar calendar spreads plunged to recent lows. Ten year yield fell 15 bps to just under 2.70.  2/10 fell over 10 bps to 237, while 5/30 posted a new recent high of 232, up 9, as 5 yrs led the yield collapse, down 18 to 143 (still double the low yield of 70).  I would note that while open interest in tens and bonds rose, OI fell 16k in Fives and 142k in euro$, primarily in the first two years.  EDZ14 had traded as low as 9914 earlier this month prior to employment data, settled 9944 yesterday as rate hikes are swept off the table.
–I guess the Fed’s motivation was not to allow the market to box them into decisions, but even with recent mixed economic data I think it was a lost opportunity and the market will test the resolve of the new Fed soon enough.
–On the other hand, housing which had been a big component of the recovery, has been restrained by higher rates.  For example, a friend that went to work at Wells Fargo in new home loans in January was just laid off along with 5000 others due to “market conditions” (thanks PD).
–Precious metals and stocks exploded higher, and pressure on EM was further alleviated. From BBG…”Bernanke Buys Time for Brazil to India as Rupee Leads Rally”  And while most welcome the rise in stocks (which perhaps solidifies Yellen’s chairmanship), the fact that people are simply paying more for a given dollar amount of sluggish earnings is of concern for the longer term.  But that’s a problem for the next Fed…
–News today includes Jobless Claims expected 341k, Existing Home Sales 5.25m, Philly Fed 10.0 and LEI +0.5.

Sept 18. FOMC announcement and economic projections

–FOMC this afternoon with announcement at 1:00pm Chicago time and press conference at 1:30.  Economic projections will extend to 2016.  Housing Starts this morning expected 915k.
–Steepening in the eurodollar curve yesterday pretty much tells you everything you need to know about consensus: strong forward guidance through 2015 and a small 10-15b tapering with additional moves being data dependent.  The first ten euro$ contracts were very well bid (2.5 years), with red pack leading the charge at +4.75 on the day.  EDU4 open interest rose 68k as one buyer lifted about 100k up to 99.505 within the span of a few minutes. The 4th and 5th year contracts, blues and golds, actually closed lower on the session, -2.25 and -2.75.  So, the ‘new’ red/gold pack spread rose 7.5 bps to nearly 294, only 4.5 bps shy of the high of the year. It occurred to me that the Fed might tacitly greenlight the steepening, as higher long end rates might help pension funds painlessly recover a portion of unfunded liabilities.  However, I think risks to the housing market outweigh the positives on that strategy.
–Here is what I think is NOT priced into the market.  1) the possibility of a move in the unemployment threshold to 6%  2) a delay in the onset of tapering 3) much slower than expected economic growth in 2H.  As fears of an aggressive tapering and accelerated FF tightening schedule have receded, the dollar has weakened, emerging markets have shown improvement, (pulled back from the abyss), and stocks have continued to strengthen.  However, precious metals and the CRB have fallen. On balance, it would seem to argue for an extremely gradual adjustment by the Fed.

Sept 17. Forward guidance trades…

–The market has been pre-occupied with whether or not the Fed ‘tapers’, but communication on forward guidance is likely to be at least as important.  The eurodollar curve appears to be reflecting this dynamic as greens outperform.  EDZ5/EDZ6 is up 4 bps to 117.   The highest this spread has been is 118.  This is now the peak of one-year calendar spreads (though EDU5/EDU6 had traded as high as 122.5).  EDZ5 currently +5.0 bp to 9845 while EDZ6 +1.0 9728.

–EDZ5 is also being supported by outright call buying.  Green Oct (2EV) 9862.5c 4.5 paid for 25k, 2EV 9875c 2.0 paid for 10k and 2EV 9900c 0.5 paid for 10k.  EDZ5 is underlying contract…strong commitment to forward guidance (and perhaps lowered projections of forward growth) would make a tightening through 2015 increasingly unlikely. 

 

Sept 17. FOMC begins today…Summers rally fades.

–An exaggerated rally due to Summers’ withdrawal from the Fed race faded as the day progressed, with the long end especially weak.  While tens fell a couple of bps to just above 2.87, the 30 yr bond rose 2.5 bps in yield to 3.87.  In euro$s, greens were the strongest with green pack nearly +12, while golds were up 6.125. As the Fed goes into deliberations today, the general tone of the market is that rates will be moving higher, eventually.  Official projections will be released after the FOMC statement, and will include guesses for 2016.  Never mind that growth projections have all been too optimistic… The target level for FF at the end of 2015 had a mean of 1% and a high of 3% in June.  The “longer run” projection was 4%. http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130619.pdf  Now we’ll get estimates for 2016, almost sure to cluster around 2.75 to 3.5% because of Fed “reversion” models.  The eurodollar curve may seize upon these projections to further steepen from Greens out.  But…what if we (here in the US) are just as “exceptional” as the Japanese – with their ten year yield of 71 bps?  As Mauldin points out in his last piece, US state and local unfunded liabilities are staggering.  There is still a crush of debt weighing on the economy which is deflationary. Illinois is among the worst offenders…to the point where Bill Daley actually dropped out of consideration for the governor’s job.  Or maybe he just thought the job is bad luck, since most former govs from this state end up in prison.
–Just a couple of other notes: CNS news notes that this year through August the Federal gov’t has collected a record amount of taxes: “$2,472,542,000,000: Record Taxation Through August; Deficit Still $755B – See more at: http://cnsnews.com/news/article/terence-p-jeffrey/2472542000000-record-taxation-through-august-deficit-still-755b#sthash.4ZQyfhax.dpuf
–Bloomberg reports that “European car sales fell in August, bringing deliveries this year to the lowest since records began in 1990,..Registrations dropped 4.9 percent to 686,957 vehicles from 722,458 cars a year earlier…”  I guess that’s supposed to be an indication of how the EU is “pulling out of the recession”.  Obama probably mushed himself yesterday by highlighting the strength of the US auto industry during his financial crisis/wealth inequality speech yesterday.
–CPI today expected +0.1 with Core +0.2.

• ABOUT:
  Former member of the CME specializing in interest rate options and yield curve strategies.

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