Sept 23, 2018. Fiscal Debt Helium

Probably the most important news regards US/China trade negotiations and the fact that China cancelled an official visit from Vice Premier Liu-He.

“Everything the US does hasn’t given any impression of sincerity and goodwill. We hope that the US side will take measures to correct its mistakes.”

(Is this why someone bought >100k Dec VIX 17 calls for 1.70 on Friday?)

About a week ago David Tepper of Appaloosa was on CNBC saying that if the China trade situation wasn’t resolved, then US equities were at risk of a significant correction.  This week’s note considers the possibility of US treasuries being in a bear market.  If a decline in stocks materializes, will it change the Fed’s trajectory or cause a large flight to safety?  Perhaps, but longer term, even a decline in asset values may not support the long end.

The ten-yr yield chart below is simply bearish, in my opinion. It shows a breakout to higher yields which had, as its impetus, the election of Donald Trump, the man who loves debt.  I think the trend for longer dated US paper has changed, in large part due to supply considerations.

Currently, US growth is on a hot streak, spurred in large measure by government borrowing and spending.  Sure, reduced regulations also figure into the equation.  It’s possible this deficit spending could spark future growth and thus ‘pay for itself’.  But for now, some are concerned about a ‘sugar high’.  Whether current growth is temporary or not, it might be bearish for longer dated paper either way.

Last week’s Z.1 quarterly report form the Fed showed the growth rate of Fed’l Gov’t borrowing was robust at a 6.9% annualized rate in Q2.  While lower than last quarter, it was still the top category.  The next highest total was corporate/business at 4.6% and then Households at 2.9% (link to Z.1 summary at bottom).

Let’s look at gov’t debt as a percent of the total amount of debt outstanding: Q2 2018 ended with $17.460T outstanding federal government debt.  That’s 34.4% of the total domestic debt of $50.710T.  With Fed plus State and Local, it’s 40.5%.   By comparison, at the end of 2007 (pre-crisis), Federal debt as % of total was 18% (Fed plus State and Local was 27%).  5 years ago in 2012: Federal was 31.8% of total. And when including State and Local 39.6%.  It was necessary to shift private debts onto the federal balance sheet in 2008/2009.  But it looks like WE’RE STILL DOING IT!  In the last 5 years Federal govt debt as percent of total went from 31.8% to 34.4%.  That’s not normal and could lead to crowding out.

“For the quarter, Federal Expenditures were up 6.0% y-o-y, while Federal Receipts were down 2.0%.” That quote is from Doug Noland’s CBB.  Doesn’t appear sustainable.

So the footprint of the Federal Gov’t is getting like Sasquatch.  In terms of stocks, it’s somewhat interesting that as the gov’t has started to turn more attention to negative aspects of big tech, the sector has taken a downturn with NYFANG off 10% from June’s highs while other indices are near new highs.

In terms of the financial crisis, many say it occurred because no one thought that house prices could go down.  Well, that’s part of it, but the real reason for a CRISIS is that prices or cash flows from highly leveraged assets decrease, and debts can’t be serviced.  If everyone owned their homes outright in 2008, then a price drop wouldn’t have made much of a difference. But in 2002-06 I knew people who were extracting cash every time they went to refinance their mortgages.  So what happens when it’s  government and not the household or business sector that has excessive debt? Then it’s time for Christine Lagarde and the IMF.

Now I want to turn to another article I skimmed on ZH citing Albert Edwards of SocGen.  Here’s a key excerpt.

As the bond rout continues, the biggest call investors have to make is whether the break of the multi-decade downtrend marks the end of the secular bull market. This is the big one. Get on the wrong side of a new multi-year bear market in government bonds and all investment portfolios will be shredded to ribbons, as bonds are the cornerstone of most equity valuation models.”

Edwards ponders the yield rise and its causes, and whether a recession is six months away (as it was in 2007).  For possible catalysts, he cites rising real rates (I’ve noted that the 5y tip yield has broken out to new highs) and allows that Brainard’s speech (which I covered last week) was a bearish factor.

In terms of a recession call, the back end of the eurodollar curve has been signaling forward problems for a long time, with contracts from late 2019 to 2021 inverted.  But what happened last week?  There‘s still inversion, but a lot less of it.  For example, EDZ9/EDZ0 which has been heavily traded, flipped from negative 2.0 a little over a week ago to +2.5 on Friday.  Perhaps not a huge move in terms of bps, but a very interesting change in dynamics if it continues.  Once again I review the key take-aways from Brainard’s speech:  The neutral rate is RISING as rates in general rise, and the TERM PREMIUM might bounce back.

Consider the chart below, which is the ten year treasury yield in white, versus the red/gold eurodollar pack spread (curve proxy) in amber.


As you can see, the red/gold pack spread is near zero even as the ten year yield is 3.07%.  The spread between the two isn’t at its greatest; in 2006/2007 it was at a maximum.  However, the percentage change in the ten year yield is greater during this hiking cycle than it was in 2004/06. Greenspan’s ‘conundrum’ has vanished.

The curve began to flatten in 2004 before the actual hiking started, and the same thing occurred to larger degree in 2014/15 prior to the first hike.  What is intereting is 2013, during the taper tantrum.  Yields went up in general AND the curve steepened.  Could that happen again?  We’re seeing a move to higher Japanese yields at the long end as the BoJ shuns that part of the curve.  No one is set up for the bear steepener.

In 2006/7 the debt was on the shoulders of households.  As home values fell it was pretty obvious that inflation would decline which would spur a bid for treasuries.  Now the debt is becoming more concentrated in the Federal Gov’t.  A lot of the demand for that debt comes from foreign entities.  What happens on a buyer’s strike?  As Druckenmiller says:  Don’t think of how things are now, think of how they MIGHT look six months to a year from now and position for that.  Does government debt matter?  In the words of the debt-king president, “We’ll see.”

Fed meeting and Powell’s press conference should be interesting.  Separation of stock market values and the real economy is likely to be a theme; don’t expect a ‘Powell put’.


9/14/2018 9/21/2018 chg
UST 2Y 277.8 280.0 2.2
UST 5Y 289.6 295.2 5.6
UST 10Y 299.0 306.6 7.6
UST 30Y 312.8 320.4 7.6
GERM 2Y -53.8 -53.3 0.5
GERM 10Y 45.0 46.2 1.2
JPN 30Y 83.9 83.9 0.0
EURO$ Z8/Z9 49.0 48.0 -1.0
EURO$ Z9/Z0 -2.0 1.5 3.5
EUR 116.22 117.49 1.27
CRUDE (1st cont) 68.77 70.78 2.01
SPX 2904.98 2929.67 24.69
VIX 12.07 11.68 -0.39

Posted on September 23, 2018 at 10:39 am by alexmanzara · Permalink
In: Eurodollar Options

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