Sept 16. Brainard the Bear















The picture above was being circulated Friday afternoon, purportedly the last shot taken by wildlife photographer Michio Hoshino in eastern Russia in 1996, minutes before he met his untimely demise.  The article that I saw said that the image was found much later as the film in the camera had only recently been developed.  However, upon looking for the image this weekend I saw a Snopes piece that debunked the story.  Fake news.  This bear did not maul Hoshino to death; the image was from a photoshop competition.  That’s good.  On the other hand, Hoshino was in fact killed by a bear on a wildlife shoot.  That’s bad.

It’s getting hard to decipher the news, and that goes for market information as well.  For example, I’ve seen many articles saying that Commitment of Trader (COT) reports depict record amounts of speculative treasury shorts.  However, I saw a post on citing the work of Adam Collins of Movement Capital that questions those assertions.  I’m not certain the analysis is valid, but the ten year surely does NOT trade like there’s an uncomfortable short position praying for a chance to cover without blowing the lid off the market.  My thought has been that the advent of bond etf’s and other trading vehicles has perhaps distorted the data and made signals other than price less important.

Let’s take a quick look at price.  Yields went up this week, especially on the short end, with the two year note +7.5 bps to a new high of 2.778%.  PPI and CPI and Retail Sales were softer than expected and yields rose.  There’s an old maxim: when news is bullish but the market doesn’t go up, that’s bearish.  Right back to our initial snarling image at top.  Perhaps more important was Brainard’s speech on Wednesday.  She had been the most important dovish voice on the Fed, but this speech was unambiguously hawkish.  She noted a difference between the long and short term neutral rate.

This year, the unemployment rate has fallen further, and job market gains have gathered strength, at the same time that the federal funds rate has increased. This combination suggests that the short-run neutral interest rate likely has also increased.  If, instead, the neutral rate had remained constant as the federal funds rate increased, we would have expected to see labor market gains slow. That inference is consistent with the formal model estimates, which indicate that the shorter-run neutral rate has gone up as the expansion has advanced.

The shift from headwinds to tailwinds may be expected to push the shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell below the longer-run equilibrium rate following the financial crisis.

Got it?  The neutral rate is a moving target and it’s going up.  She then ties the short-end neutral rate to the curve, and indicates that ‘term premium’ is also a moving target which has been depressed by central bank purchases.

These developments raise the prospect that, at some point, the Committee’s setting of the federal funds rate will exceed current estimates of the longer-run federal funds rate. Indeed, the median projection in the SEP has this property. This raises the possibility of a flattening or inversion of the yield curve in the event that term premiums do not rise from their currently very low levels.

As friend WHM concluded, “There are no more doves on the Fed.”  Even Chicago’s Evans has changed his tune, who this week said rates should rise, as the economy is performing well, and that he’s “more comfortable with the inflation outlook.”

Let’s consider Eurodollars and the messages being sent by large trades and by open interest.  In January I wrote a post entitled Red December.  This was and still is the December’19 contract, but as of Monday EDZ9 will be the first red.  I wrote at the time that EDZ19 was seeing massive gains in open interest.  On January 5th, there had been a seller of 125k EDZ8/EDZ9/EDZ0 butterfly at 15 to 14.5.  This fly, like many of the near butterflies, settled at a new high Friday of 51.0.  EDZ8/EDZ9 settled at a new high of 49.0, having exploded from 39.5 last week, while EDZ9/EDZ0 closed at -2.0. There has been heavy outright selling of EDZ’19, and additional pressure on the contract due to related buys of calendar spreads.  For example, large buying of EDU9/EDZ9 last week for 5.5 (settled there on Friday).

In the beginning of the year, total open interest in euro$’s was 12.745 million.  By the middle of January it had surged to 14.367m.  Currently it’s 15.008m   In terms of EDZ’19, by March the open interest in that contract alone was well over 2 million, and as of Friday it once again pushed over 2 million, being the largest OI of any contract on the strip, with the next closest being EDZ18 at 1.8 million.  EDZ19 made a new low this week, as did the contracts in the immediate vicinity, including EDH20.  What is interesting about EDH20, is that there was a huge targeted trade on that particular underlying: a buy of 250k 0EH 9687.5/9662.5/96.375 put butterflies as 1 x 3 x 2 at premium of 1.5 to 2.5.  This means that he bought the upper put spread once and sold the lower put spread two times.  Assuming a price of 2.5, the top breakeven is 9685, and the lower breakeven is 9651.25.  Maximum loss is below 9637.5.  Below the lowest strike at expiry, the top put spread fills out to 25, but the lower put spread also fills out for a loss of 50.  The target is the middle strike, 9662.5, against a current price of 9685.5.  Given that the September FOMC is essentially fully priced for a hike, and that odds for a December hike are better than 75%, this trade can be thought of as a play for an additional move in March.

Below is a chart of EDZ19.  New lows with a rise in open interest helping to confirm the move.  That’s not to say that there won’t be some consolidation. However, the sentiment and price action are clearly bearish.  Eurodollar trades are saying the market is going lower but will perhaps be limited on the downside.  Longer term one-year calendars from late 2019 to 2021 signal that higher rates will, by that time, seriously slow the economy.




Now let’s take a minute on the longer end.  The ten year yield closed out the week just below 3% at 2.961%.  As the charts below indicate, just above the 3% area is resistance, from both a short and long term perspective. The high close of the year has been 3.11% set in May.   It appears as though increased supply is starting figure into pricing, and tentative signs of consolidation in some of the EM currencies may tend to diminish the bid for treasuries, if only at the margin.

My personal bias had been that there might be a near term pause in tightening, and that the curve would steepen as a result.  Brainard squashed those ideas.  Even a pull back in stocks doesn’t seem likely to sway the Fed.  As Brainard notes, “…equity valuations are elevated relative to historical patterns.”

Posted on September 16, 2018 at 3:04 pm by alexmanzara · Permalink
In: Eurodollar Options

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