Sept 25. Vol in an uncertain world

The Fed didn’t hike, much to the consternation of some, but additionally, Chair Yellen’s testimony leaned a bit to the dovish side.  As a result, yields fell and the curve flattened.  It’s somewhat interesting to note that while Japan is apparently trying to steepen its curve in order to help financial institutions, the effect of the Fed’s meeting was a flatter curve; a bid to longer duration assets, both bonds and stocks.  As Tad Rivelle pointed out so eloquently in his paper ‘Twilight of the Central Bankers’ , “Growth is not a simple function of higher asset prices.”  We also had an evaporation of vol in the interest rate arena, to levels which seem untenable.  More on vol levels below.

First, the Bank of Japan is sort of like the movie Planes, Trains and Automobiles; they can’t quite find a vehicle to reach their inflation target.  “You’re going the wrong way!” “Oh he’s drunk.  How do they know where we’re going?”  This week the BoJ left  the funding rate at -10 bps but shifted to yield targeting on the ten year, which should tend to steepen the curve beyond that point and provide relief in the form of carry to insurance companies and other financial institutions.  Bernanke said in his blog, “Pegging a long-term yield as the BoJ now plans to do, amounts to setting a target price rather than a target quantity.  …In that regard, it was puzzling that the BoJ retained its 80 trillion yen quantity target for JGB purchases; one of these two targets is redundant.”

There were several charitable research notes mentioning that yield targeting had a successful precedent in the US in the 1940’s, but that episode was specifically related to wartime financing, and ultimately the US treasury absorbed much of the losses, as also occurred in the 2008/09 crisis.  In other words, it’s hard to imagine a graceful exit to yield targeting.  There’s a paper on the Fed’s website that summarizes this period.

In a compromise struck on March 20, 1942, Federal Reserve and Treasury officials agreed to cap the long-term Treasury yield at 2.5%, the seven to nine year yield at 2%, and the one year rate at 7/8 %.  The Federal Reserve strenuously opposed the Treasury’s initial proposal to increase reserves, but eventually acquiesced to an alternative plan of posting a 3/8 % rate on short-term Treasury bills.  At the time, this 3/8 % peg was seen as relatively innocuous, partly because the rate was slightly higher than the then-prevailing rate of 1/4 % on Treasury bills, and also because it was not then perceived as an indefinite commitment.  Interestingly, the caps on long-term interest rates were never formally announced, perhaps to avoid embarrassment in case the policy proved unsuccessful.

The maintenance of the low bill rate peg during much of the postwar boom is remarkable in and of itself.  The Federal Reserve Bank of NY had advocated an increase in the bill rate as early as 1944, but Chairman Eccles was reluctant to make such a move until the end of the war.  One reason for this reluctance had to do with the stability of the banking system.  Banks had absorbed a large amount of government securities relative to their available capital during WWII, which left them particularly vulnerable to increasing interest rates… If the price declines were sharp they could have highly unfavorable repercussions on the functioning of financial institutions and if carried far enough might even weaken public confidence in such institutions.

In March of 1951…the Fed and Treasury negotiated the Accord that ended the direct setting of long term interest rates, thus recognizing “the dilemma presented by the conflicting problems of debt mgmt. and credit restraint in the inflationary situation which developed.”  … One difficult issue was how to deal with losses inflicted on bondholders by the rise in long term rates. The solution was to allow bondholders to convert old 2.5% bonds into non-marketable 29 yr bonds convertible into 5 yr notes…  Thus the treasury absorbed much of the losses associated with its renunciation of the interest rate caps.

Perhaps a bit too much on Japan above, but its central bank has been a key player in fighting deflation.  Also, as shown above, economic problems tend to rhyme.  Given the fact that in terms of global GDP China has completely overshadowed Japan (in 1980 Japan was nearly 8% of global GDP and China was 5%, while in 2008 Japan was less than 6% and China nearly 18%), maybe it’s better to spend some time there, and indeed there was dissection of both BIS and Fitch reports suggesting China’s debt growth is unsustainable.   From the Telegraph, “Bad debts in the Chinese banking system are ten times higher than officially admitted, and rescue costs could reach a third of GDP if authorities let the crisis fester, Fitch Ratings has warned.”  Really the move in the renminbi says it all, having been at 6.1 at the end of 2014 and trending ever lower (in terms of the dollar) to nearly 6.7 now, (the high set in Q2).

Moving to the ECB, Draghi is scheduled to speak to a German parliamentary committee on Wednesday and take questions.  RTRS: “Schaeuble, a fierce critic of Draghi, urged members of the German finance committee to ask tough questions about Draghi’s monetary policy when he testifies before the committee on Wednesday, the newspaper said, citing meeting participants. …Draghi is due to address the finance and budget committees of the German parliament on Wednesday.”  Also, according to a report in Focus magazine picked up by BBG, Merkel said she won’t use state money to bail out DB (which closed near its low).  A global case of schadenfreude as a depositor bail-in looms?

Now to the US, where Monday’s debate between Clinton and Trump holds center stage.  There hasn’t been much of an election trade, though many markets have priced implied volatility higher after the election than immediately preceding.  For example, a friend noted that in the e-minis, there’s a 2% vol spread between week-3 Oct and week-3 Nov, and nearly a 2% spread between GCX and GCZ.  In treasuries, vol simply seems too low against a backdrop of 1) a critical employment report on Oct 7, 2) the upcoming US election, 3) general erosion in the faith of central banks and more specifically 4) the idea that Japan could spark a shift to steeper curves globally.  Clearly vol suppression is related to yield suppression in a world of the central bank put, but there was an interesting (bigger picture) note related to the last G20 meeting:  ‘Heads of state and government representing the world’s largest economies used words like “fear,” “uncertainty,” “risk,” and “terror” 87 percent more often on average than during last year’s gathering.’  Consider the chart below of ten year vol.  Does it make sense to be at 2014 lows?


A quick thought on the election.  In the last two years the Mexican Peso has lost nearly 50% of its value, partially due to the decline in oil and more recently over fears of Trump.  Some markets are clearly more concerned about the election outcome than others.  It’s worth considering that a large infrastructure re-building program under Trump could occur, which would stimulate the economy (and blow out the deficit).   Note that state tax revenues are reflecting a weakening environment: “According to preliminary estimates from Rockefeller Institute of Government, tax collections will be down 2.1% in the second quarter relative to last year, reflecting a decline of 3.3% in personal income taxes and a 9.2% plunge in corporate tax collections.”  Also, the three month moving average of the Chicago Fed Nat’l Activity Index has had nineteen consecutive negative months.



9/16/2016 9/23/2016 chg
UST 2Y 77.4 75.0 -2.4
UST 5Y 120.7 115.3 -5.4
UST 10Y 170.0 161.3 -8.7
UST 30Y 244.8 233.7 -11.1
GERM 2Y -65.3 -67.1 -1.8
GERM 10Y 0.7 -8.2 -8.9
EURO$ Z6/Z7 16.0 15.5 -0.5
EURO$ Z7/Z8 15.0 12.5 -2.5
EUR 111.57 112.28 0.71
CRUDE (1st cont) 43.62 44.48 0.86
SPX 2139.16 2164.69 25.53
VIX 15.37 12.29 -3.08


Posted on September 25, 2016 at 10:54 am by alexmanzara · Permalink
In: Eurodollar Options

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