Sept 27. Stress tests
There’s a classic definition of stress that I have often felt:
“The confusion caused when one’s mind overrides the body’s natural desire to choke the living sh*t out of some a**hole that desperately deserves it.”
By now, people are aware of Janet Yellen’s speech last Thursday where she seemed confused and began to choke, notably just before concluding with this: “Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.” It was a long speech, so it’s probably not exactly fair to say this, but maybe she really doesn’t think it IS appropriate to hike later this year, maybe that’s what she’s choking on and confused about…her colleagues are pushing for a rate hike and rather than going with her own analysis, she is being stressed into it. Hence the caveat about economic surprises.
The Fed requires strong leadership. It’s a tough job to keep divergent opinions in line. Case in point, John Boehner, who just resigned his House speakership rather than face an uprising from the far right. From the analysis I’ve seen, this move will likely avert a government shutdown in October, but going into the end of the year, a huge fight looms over a debt ceiling increase and…a gov’t shutdown. This issue is likely to dominate the news going into December. Does that fit into the idea of an economic surprise? In my opinion it significantly reduces the odds for a hike this year. If it doesn’t happen in October, it surely won’t happen in December. Of course, the Fed could ignore the political discourse, and send a message from ALL central bankers to ALL governments, that it’s not solely up to monetary policy to keep the engine humming. But I doubt it.
We just came off a strong revision to Q2 GDP growth of 3.9%. However, the Atlanta Fed’s GDP Now estimate for Q3 is just 1.4%, and has been hovering between 1.3 and 1.5 since mid-August. Earnings estimates for Q3 are expected down 3.9% year over year. Market based measures of forward inflation are hitting new lows, for example I marked the ten year note to tip spread at just 148 bps on Friday, a new low for the year. It started the year at 170. It’s hardly compelling to argue that the Fed’s behind the curve.
What about current market indications of stress? Whether one looks at junk bond spreads, or financial stress/conditions indicators published by many of the regional Fed banks (Chicago, Cleveland, KC or St Louis), they have all turned higher, indicating potential problems. [Links below]
What about swap spreads? They usually widen during times of stress as market participants rush to the safety of treasuries. But now they are plunging. The five year spent the first half of 2015 between 10 and 20 bps, but has now collapsed to a new low of 1.75. The ten year was between 8 and 15 bps in the first half, but has cascaded to -2, testing levels not seen since 2010 (fives are actually below 2010 marks). The reason given, in part, is that foreign central banks are unloading UST reserves in support of their own currencies. Perhaps the market also realizes that central banks will do everything in their power to save financial institutions. Does too big to fail ironically cause swap spreads to come under pressure during episodes of stress?
The Nasdaq Biotech Index (NBI) closed at a new low Friday, down 22% from July’s high, essentially a round trip from the beginning of the year. The VIX was only 1.3 higher on the week, but remains well above 20, closing at 23.6. We’re all aware of stress in the energy patch, and in commodities in general. Lumber at around 216 is as low as it’s been since 2011, almost half off the high in 2013 of 400. Same with copper, which closed at a new low for the month of September, and is nearly 50% below the price of five years ago. Perhaps the low input prices, including interest rates, are good for homebuilders, but trying to re-pump global demand back to unreasonable levels with a monetary compressor just doesn’t seem feasible. Are more ‘normal’ commodity prices suggesting that interest rate ‘normalization’ should also occur? Maybe that would be the case if there wasn’t an overhang of debt servicing costs to contend with, but there is, hence corporate bond spreads widening.
For now, there seems to be an overwhelming preponderance of negative news that is likely to pressure risk assets. Lower prices for risk assets will likely translate into lower interest rates. The big events of the week are Dudley’s interview on Monday with the WSJ, Stanley Fischer’s speech Friday on Macroprudential Regulation, and, of course, the jobs report on Friday. Jobless claims have been quite low, and there are several other factors which indicate the risk of a stronger than expected payroll number. Even if the data is strong, there will be eager buyers on dips. In tens, 228-230 will likely cap the yield, roughly corresponding with TYZ 126-16, the low just before the Sept FOMC.
The initial target for tens should be around 206, which is the halfway point on the year’s range and seems to have gravitational pull. This level is around 128-24 in futures. Though all fixed income contracts have had big rallies since the Fed meeting, there is likely more to go. For example, red and green Eurodollar contracts this week surpassed their highs from the August 24 stock market swoon, and that’s in spite of the ‘hike this year’ mentality. Absolute levels of back month Eurodollars seem awfully pricey, and calendar spreads are quite tight, however, a continued squeeze to lower yields and a flatter curve at the front end is probable in my opinion, and the trade of most pain.
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| https://www.chicagofed.org/research/data/nfci/background
https://research.stlouisfed.org/fred2/series/STLFSI https://research.stlouisfed.org/fred2/series/KCFSI
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