Re-pricing of risks?

A friend of mine went to see a wealth manager last week.  This particular individual isn’t particularly comfortable with stocks at their current levels; I would say prudently risk averse.  Therefore, one recommendation was high quality corporate bonds, which makes sense.  What I would note is that the market is rather selectively pricing risk.  For example, one year libor has shot up to 153 bps, up 40 bps since February, nearly as high as the ten year note which ended the week at 163.  But the BAML BBB option adjusted spread is near the low of the year around 183. Sure, the rise in libor is mostly regulatory in nature, but it really boils down to risk aversion.  Institutional investors are shifting over to government money market funds, because they don’t want to take the risk that these accounts break the buck or are gated.  At the same time we continue to hear about the insatiable reach for yield.  Is it about yield or about beating your benchmark?  In a way, the switch in money market funds shows that pricing of risk and liquidity can be a fickle thing.  We reach for yield with YOUR money (to match  benchmarks) but not with ours.  In a broader perspective, it’s an indication that when official support is withdrawn, either through QE or rate changes, or through the erosion of central bank credibility, then prices adjust to new risk, and not necessarily in a graceful way.  We had a taste of that adjustment at the start of the year, after December’s rate hike.  By mid February, communications shifted dovishly and “stability” was restored.

Now the Fed is taking another step toward removal of accommodation.  Yellen on Friday said, “…I believe the case for an increase in the federal funds rate has strengthened in recent months.”  Followed by Fischer, “We’re reasonably close to what is thought of as full employment. [The] inflation rate this year is higher than last year’s. It’s still not up to 2 percent. But it’s been growing.”  When asked if there could be a hike in September and possibly more than one this year Fischer replied: “I think what [Yellen] said today was consistent with answering yes to both your questions, but these are not things we know until we see the data.”  Well yes, actually these are things we do know, or at least this: The Fed will NOT hike two times before the end of the year.  However, the pricing for one hike by year end is nearly there, as reflected by January 2017 Fed Funds.  That contract settled at 9941.5, or a rate of 58.5, versus the Fed effective rate of 40 bps.  As mentioned previously, both the gradual acceleration of wage data and the coming yoy comparisons with respect to inflation will bolster the rate hike argument.  However, economic data is likely to continue mixed, and may even tend to disappoint over the medium term.

Having covered the boilerplate Jackson Hole summary quotes, let’s shift to a tangentially related topic. There has been a lot of press about european bank shares.  Recently I have noticed a bit more attention being given to Saudi bank shares.  For example, the Tadawul All Share Banking Index is at a new low of 12830, even lower than the start of the year when oil was plunging.  Note that one year ago the level was around 19500, a decline of around 1/3 since last August.  The largest bank is National Commercial Bank, said to be a proxy for the royal family’s wealth.  New low, down 50% from the high of last year.

There was an article in the Wall Street Journal noting that the world’s largest oil companies have taken on huge amounts of debt as the price of oil has fallen.  For example, Exxon and Chevron had no debt in 2013, now Exxon has $40b and Chevron is close.  BP is about stable, but still has $30b, and Shell’s borrowings have exploded to over $70 billion. According to the article, these four have“…net debt of $184 billion—more than double their debt levels in 2014.” “The companies spent more than 100% of their profits on dividends last year.  …Just a decade ago, these four companies were hauled before Congress to explain ‘windfall profits’ but now can’t cover expenses with normal cash flow.”

What do Saudi bank shares and oil company debts have to do with the US curve?  Well, Yellen and other Fed officials have repeatedly referred to weakness in energy prices as a restraining factor on inflation. I’m no expert, but I think the Saudis are still thought of as a swing producer in terms of setting marginal prices (though perhaps now N American shale producers are in that role).  In any case, though they have publicly stated they want to move away from oil as their prime source of income, they desperately need higher prices, as do the oil companies.  Even without further price boosts, yoy comparisons are going to have a big influence on inflation data, and my conclusion is that oil prices will edge higher.  The question is, will an inflation premium again be a feature of the long end?  And after the first hike, will the curve steepen or flatten?

On Friday, both 2/10 and 5/30 treasury spreads made new lows, with the former just below 79 bps and the latter at 105.5.  This price action indicates that higher rates will restrain the economy and inflation. However, near Eurodollar calendars made new recent highs.  For example, Dec’16/Dec’17 closed at 19, having spent the past month between 12 and 16.  There was a large buyer Friday of EDZ7/EDZ9 2 year spreads for 26.5 (settled 28).  It appears it might have been a roll as EDZ7 open interest declined by 13k and EDZ19 was up 16.7k.  In any event, at just above ¼% for two year calendars, there is a lot of room to build in an inflation premium, or a gov’t infrastructure spending premium, or a “Fed no longer has our backs” premium.   I am of the opinion that the US faces a stagflationary environment which should produce higher long end rates and higher spreads, at least on the Eurodollar curve from reds through golds.  I am again attaching a chart (Global Tens) showing that JGBs, bunds, and finally this week, ten yr treasury yields have all broken downward sloping trendlines.  A scenario that features higher yields even as equities decline is hard to envision, but I think we are heading in that direction.  Bonds and stocks went up together, they can go down together as well.

Posted on August 29, 2016 at 5:06 am by alexmanzara · Permalink
In: Eurodollar Options

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