Sept 4. Fed hiking schedule still up in the air

Friday’s employment data was tepid with Nonfarms up 151k, but not quite soft enough to take a September hike off the table as the previous month was revised +20k to 275k.  On the week, treasury yields fell a few bps, with the two year down just over 5 to 79.  The curve edged slightly steeper.  Fed Funds contracts marginally shifted the odds further in favor of a December hike.  October FF settled 99.545 vs the just expired August contract at 99.603, a spread of 5.8 bps, indicating around 1-in-4 for September.  I would note that October has the largest open interest of any FF contract, followed by November and January.  The Nov/Jan calendar spread isolates odds of a Dec hike; it settled at 9 bps, so better than 1 in 3 for December.  The Sept/Dec Eurodollar calendar spread closed at a new high of 8.25 bps, with EDU6 +1 on Friday, and EDZ6 -1.

Markets have been coiling sideways, spreads are stuck in cement.  Every euro$ one-year calendar spread from Dec’16/Dec’17 to Dec’18/Dec’19 is between 13 and 17 bps.  Implied vols are low and were further pressured Friday as the week ahead is light on news. (Service ISM Tuesday, Beige Book Wed).  One market that did tentatively break out of this year’s downward channel is $/yen (orange line).

Yen GT5 Sept 2016

Also included on the chart above is the US Five Year Treasury yield in white.  Not much of a move this week, but it too has broken this year’s downtrend.  Nothing too surprising on this chart except for the extremely close tracking since March.  The Fed is looking to hike, so rates push higher and USD strengthens in a welcome development for the BoJ.

Moving from Japan to China, the chart below touches on the Impossible Trinity, which states that out of three policy objectives of setting the FX rate, or the domestic interest rate, or allowing the free flow of capital, only two can be achieved.  The chart below suggests that China has chosen to focus on its goals through policies 1 & 2.  Chinese Reserves are in white, the yuan in red (inverted on this chart so that down and to the right indicates a weaker yuan), and China’s ten year yield is in green.  What’s interesting here is that reserves have been held constant in 2016 and rates have fallen, which makes it appear as if further currency depreciation is in the works.  In 2014-15 China was spending reserves to hold the currency relatively steady in the face of a slowing economy.  In August 2015 came the overt devaluation which has continued ever since.

China trilemma

While currency depreciation had been associated with capital flows out of China into “relative” stores of value including high end real estate in the US and elsewhere, there are signs that these flows are being staunched.

For example, a Bloomberg article this week noted that high end projects in Manhattan are offering discounts and incentives.  “…developers are coping with a luxury condo glut and adjusting to a new reality after years of building to meet seemingly insatiable demand.  With the market now sputtering, they’re altering sales plans and making behind the scenes deals…”   An FT Alphaville story notes that Swiss watches have seen a sudden drop in demand related in part to a Chinese anti-corruption and gift giving crackdown.

Stephen Roach writes that “…the Chinese economy accounts for fully 18% of world output (measured on a purchasing-power-parity basis).   If Chinese GDP growth reaches 6.7% in 2016 – in line with the government’s official target – China would account for 1.2 percentage points of world GDP growth.”

However, if China is attempting to meet those growth targets through fx depreciation, it only adds to global pressures to construct trade barriers.  The free flow of goods and services and capital tends to hold prices down, restrictions on those flows will have the opposite stagflationary effect.

Once again, the conclusion is not that US growth is about to accelerate and force rate increases. (However, note that Q3 estimates from the Atlanta Fed and NY Fed aren’t too shabby at 3.5% and 2.8% respectively).  It’s that years of weak capex have led to productivity declines (unit labor costs +4.3% in the last quarter), and that trade impediments create higher prices at the margin.  Central banks are aware of monetary policy limitations and want to push fiscal initiatives.


8/26/2016 9/2/2016 chg
UST 2Y 84.3 79.0 -5.3
UST 5Y 123.7 118.8 -4.9
UST 10Y 163.1 159.6 -3.5
UST 30Y 229.2 227.0 -2.2
GERM 2Y -61.6 -63.0 -1.4
GERM 10Y -7.2 -4.3 2.9
EURO$ Z6/Z7 19.0 17.0 -2.0
EURO$ Z7/Z8 14.0 12.5 -1.5
EUR 111.97 111.56 -0.41
CRUDE (1st cont) 47.64 44.44 -3.20
SPX 2169.04 2179.98 10.94
VIX 13.65 11.98 -1.67


Posted on September 5, 2016 at 2:45 pm by alexmanzara · Permalink
In: Eurodollar Options

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