Stability based on confidence

Jan 20, 2019

Markets continued to rebound in the month of January, primarily in response to words of encouragement from the Fed.  Stocks powered to new highs for the year, as did crude oil, as did copper as did treasury yields.  However, against the backdrop of strong labor conditions underpinning the domestic economy, renewed ‘risk-on’ characteristics  could spur the Fed to moderate or even reverse the dovish talk that followed the late December plunge.

Interest rate curves are now starting to foreshadow caution about the possibility of a switch back to a tightening bias after a March pause.  Near Eurodollar calendar spreads closed at the highs for the year.  Most notable is EDH19/EDH20 which settled 2.5 bps, a rally of 13 bps on the week, and nearly 30 from the low of the year which was set at -27 on January 3.  On the FF curve, the February/April spread, which indicates odds of a Fed hike or ease at the March 20th FOMC, settled at zero (both contracts at 97.595, essentially locked at the current Fed effective rate of 2.40% so there’s the ‘pause’).  However, the May/July spread, which prices odds for the June 19th FOMC has popped up to 5 bps, signaling a 20% chance of a June hike.  Then for September, the August/Oct spread is 0.5.  The pricing is somewhat odd, though considerations with respect to t-bill supply may be figuring into some of these spreads, as a debt limit fight gets underway.  As the debt-limit deadline draws closer, bill supply may be suspended, only to come flooding back as an agreement is reached.  Mid-August is supposedly the drop-dead date.

Further back, the curve flattened.  The red pack (second year) has led the interest rate curve lower falling 13.25 bps this week.  The red/blue pack spread (2nd to 4th years) once again inverted, closing at minus 1, a new low for the past month.  In treasuries on the week, 2’s gained 6.9 bps, fives 9.4, tens 8.5 and bonds 5.9.  There’s been a marginal decline in inflation expectations/ term premium as a tightening bias re-emerged.   

With the Martin Luther King holiday Monday and a sparse economic calendar, the market’s pendulum should barely swing this week.  However, the continuing government shutdown could begin to take a greater toll on growth prospects, as Brainard warned this weekend.  Here’s a quote (unrelated to Brainard) that caught my attention:

One senior Republican Senate staffer told me he could envision the shutdown lasting until March, when federal funding dries up for food stamps—a crisis that would be hard for Washington to ignore. “Not only are there going to be a lot of hungry families,” he said, “but there are going to be a lot of Walmarts and Safeways and Krogers that are missing revenue.”

And here’s a small ‘congratulatory’ note from Martin Armstrong regarding Alexandria Ocasio-Cortez being placed on the Financial Services Committee chaired by Maxine Waters:

We can count on wild and crazy statements coming from this committee that will disrupt the world economy and confuse the hell out of people.  It certainly appears with every step we take, we are moving in the direction of a complete collapse in confidence.  I can’t imagine the bond market will survive comments coming from these two pillars of financial stupidity.

Of course, that’s a bit over the top (as there are more than TWO pillars).  But the point about confidence in the US treasury market may be getting uncomfortably close to the mark given 1) the current shutdown 2) expected fireworks for the debt-ceiling limit 3) an increasing budget deficit.  Bloomberg ran a story this weekend noting that the composition of auction buyers has shifted towards domestic private buyers who are more yield sensitive:   

America’s $15.6 trillion government-bond market — the world’s largest and most liquid — isn’t necessarily losing customers. But the biggest growth in demand is coming from the private sector, rather than the public side. That matters because if these price-sensitive buyers start pushing for better rates, it could help drive up the average interest rate on the nation’s debt, which is already close to a nine-year high. [link at bottom]

I want to turn now to a brief discussion of US Household (HH) Sector finances.  On and off there are strident warnings about credit card debt or student loans in the press.  But if there’s a crisis lurking around the corner, it’s not likely to be sparked by outlandish HH borrowing, it’s more likely to come from the corporate or government sectors.  After the crisis, private debts were shifted onto the government’s balance sheet.  Now, household obligations are being shifted to the business sector.

The chart below is a bit hard to see, but it’s from the St Louis Fed: HH debt as a percent of GDP.  In the crisis, HH debt to GDP was near 100% but it’s been around 80% since 2015. 

In terms of the Debt Service Ratio or DSR, a subset of the Fed’s HH Financial Obligation Ratio, it has fallen to a record low (since the data began in 1980) of 9.82% of Disposable Personal Income as of Q3 2018.  It’s a surprise to many people, but the outstanding level of mortgage debt to households has not yet exceeded the high of late 2007 at $10.625T.  As of Q3 2018. ELEVEN YEARS LATER, it’s $10.274T.  (Green line on the chart below).  The DSR is composed of Mortgages and Consumer Credit.  The mortgage part is also at a record low 4.24%.

It’s pretty clear that the HH sector has morphed into a class of renters rather than owners.  For homeowners, the average percentage of home equity has gone from 59.5% in 2005 down to a low of 36.5% in 2009 when prices dropped, back to 59.9% now.  But the public is now leasing apartments and cars, which, in a way, shifts the ultimate debt burden off the HH sector to the Business/Corp sector.  The total HH Financial Obligation Ratio (which is the Debt Service Ratio PLUS Rent, Auto leases, Home insurance and Property Taxes) has been more stable and is now 15.29% of Disposable Personal Income.  This is still historically on the low side, [link to data at bottom] but it’s not at a record low.  The point is, it’s much easier to walk away from an apartment or auto lease than it is a mortgage or auto loan. As the chart below shows, New and Existing Home sales turned down in 2018 as higher rates filtered through.  Home prices are no longer increasing due to lower financing rates. 

The conclusion of this section is a reminder of the old adage, if the bank loans you $100,000 and you can’t pay it, then YOU have a problem.  But if the bank loans you $100,000,000 and you can’t pay it, the BANK has a problem.  The finances of the HH, wage-earning sector look pretty good.  Even student loans that aren’t being serviced are probably more of a problem for the government (which owns the majority) than the debtors.  At the margin, there is now less certainty that contracts/leases (which are now shorter in length and don’t involve the loss of equity) will be honored in a downturn.  In turn there’s less certainty of investor demand for loans at a given rate.  Foreign governments building USD reserves are likely a more stable source of treasury demand than ETFs.  Horizons are shortening throughout the system.  If confidence really does begin to erode, the big unwind might happen quickly.

1/11/2019 1/18/2019 chg
UST 2Y 254.3 261.2 6.9
UST 5Y 252.4 261.8 9.4
UST 10Y 269.7 278.2 8.5
UST 30Y 303.5 309.4 5.9
GERM 2Y -58.7 -58.1 0.6
GERM 10Y 23.9 26.2 2.3
JPN 30Y 69.6 69.3 -0.3
EURO$ H9/H0 -10.5 2.5 13.0
EURO$ H0/H1 -12.5 -10.5 2.0
EUR 114.69 113.64 -1.05
CRUDE (1st cont) 51.90 54.04 2.14
SPX 2596.26 2670.71 74.45
VIX 18.19 17.80 -0.39
Posted on January 20, 2019 at 1:42 pm by alexmanzara · Permalink
In: Eurodollar Options

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