The dealings of my trade…

Being that it’s Christmas week, I was going to run with a theme from ‘It’s a Wonderful Life’.  Our hero George Bailey is pleading with the townsfolk not to force a run on the Building and Loan:

Can’t you understand what’s happening here?  Don’t you see what’s happening? Potter isn’t selling.  Potter’s buying!  And why?  Because we’re panicky and he’s not.  That’s why.  He’s pickin’ up some bargain.  Now, we can get through this thing all right.  We’ve got to stick together though.  We’ve got to have faith in each other.

There’s just one problem though.  Potter IS selling!

There were some extraordinary gains in the two-plus years from the start of 2016 to the highs in 2018, and we’ve given back around half. In SPX, from the low in 2016 to the high made earlier this year, the 50% mark is 2375, vs a close Friday of 2416.62.  In Russell 2k we’re through the halfway back level and in the Nasdaq it’s around 6191 vs 6333 on Friday. The DJIA is similarly coming close; Transports are through. This has been a year which featured the withdrawal of central bank liquidity, both through rate hikes and balance sheet roll-off.  Two things happened in the beginning of October to accelerate the selling: first, Powell’s now famous utterance “…we’re a long way from neutral” and second, the increase in “auto-pilot” balance sheet roll-off to $50 billion per month.  Powell walked back the neutral comment, which has now been softened to allow that we’re at the lower band of neutral.  However, the Fed considers the balance sheet run-off to be rolling along swimmingly.  No change anticipated according to last week’s FOMC.  The Fed delivered a 25 bp hike in the FF target range, with a rise of only 20 bps in IOER, but the Quantitative Tightening schedule was left on auto-pilot, and risks to the domestic economy, while acknowledged, weren’t emphasized, in what was termed a strong economy.

John Williams, President of the NY Fed and FOMC Vice-Chair, was interviewed by CNBC’s Steve Liesman on Friday.  At the outset, in defense of the Fed’s hike, he said several times that the economy is strong, primarily falling back on the [lagging] employment indicators. Liesman’s core line of questioning concerned whether the Fed appreciated signals the market was sending.  Williams emphasized that the Fed is now data-dependent, and expects a healthy economy in 2019, but is attuned to growing risks.  Most importantly, he said, “…if there’s a material deterioration in the economic outlook, obviously we will reconsider our path for the short term interest rate and would adjust policy to best achieve our goals.  But we also said we would reconsider the balance sheet normalization and may even end that process…if that’s appropriate to achieve our goals.”  Williams agreed with Powell that “we’re now basically at the bottom end of the range of neutral interest rates in terms of our best estimates.”  He also said, “…you and others have noted we only lowered our forecast for growth by 0.2 for 2019 but that’s in the context of a much shallower path for the fed funds rate.”

In looking back at the history of Fed actions (link below) the shortest time frame I found between a hike and an ease was in 1987 for the stock crash.  This was the start of the Greenspan era; a hike on Sept 22, 1987 to 7.25%, followed by a cut just one month later on Oct 19, 1987 to 6.75%.  Amazingly, the low in that cycle was only 6.5%, in February 1988.  Prior to Greenspan, FF’s jumped around constantly.  In 1980 for example, the year started at 15%, was jacked to 20%, and ended at 18%.  Besides the crash, the next shortest period between a hike and a cut was February 1, 1995 to July 6, 1995, from a FF target of 6% to 5.75%, a little over 5 months.

A MarketWatch article (thanks Aldo) notes a current similarity to the 1987 crash period: the average daily moves for DJIA, SPX, and Russell have been the worst in this month of December since October of 1987.  SPX average daily move -0.80%, DJIA -0.78% and RTY -1.05%. 

I think the Fed will deliver an ‘ease’ by the beginning of next year, in the second quickest turnaround since the crash of 87.  They will probably try to wait for the January 30 FOMC.  Using the cover of enormous treasury supply, the Fed will announce either a trimming of the balance sheet reduction to something like $20 billion per month, or a complete cessation, most likely the latter.    

Last week I wrote about Banks and Central Banks, as the financial backbone of monetary transmission is of the utmost importance.  They bail out the banks for a reason.  Weakness continues globally. The XLF financial etf is down 25% from the high set at the start of the year.  Individual names are down significantly more, as I wrote last week.  For example GS is down 42%.  In Europe DB Is down over 50% and CS is close to having been cut in half.  The Eurostoxx bank index is down 33% while the Italy bank index is down 40%.

This week has seen an amazing amount of turmoil.  There have been whispers of collateral shortages and hoarding, funding issues, etc.  Obviously stress has increased significantly.  The VIX closed just above 30, not quite at levels seen in the great blow-up of February, but definitely in the warning zone, up from around 16 at the start of December.  However, I am going to consider some market signals (along Liesman’s line of inquiry) that paint a mixed picture.  I’ve looked at the weekly closing spread between the new SOFR (Secured Overnight Funding Repo) contract and EDH8, and it has been stable since November between 29.5 and 32.  Not much sign of crazy stress there.  In terms of forward proxies for Libor/OIS, spreads are also pretty unremarkable.  While the FFF9 to EDZ8 spread got out to 41 to 43 bps prior to EDZ8 expiry, the current readings are: FFJ9 to EDH9 33.0, FFN9 to EDM9 28.5 and FFV9 to FFU9 26.5.  Then, FFF20 to EDZ9 is 29.0, reflecting well known weakness in the EDZ9 contract.

Implied vol in interest rate products remains low, though it firmed last week.  In fact, while yields dropped across the board, with the greatest decline in the 30 year bond at 11.4 bps to 3.027%, a real flight to quality in the sense of a mad grab for treasury calls didn’t really occur.    

Of more concern is the rise in corporate spreads.  We know that corporate debt as a percent of GDP is at a record high; during the years of ZIRP, companies were incentivized to borrow for takeovers, or to buy back their own shares.  EPS gained, balance sheet measures suffered, all the more apparent at higher rates when the aforementioned debt needs to be rolled.  Clearly, problems surfaced in the energy/emerging market rout of late 2015 and early 2016.  Currently, spreads have been rising but are well below the spike of early 2016.  However, just looking at the spread is a bit disingenuous. Consider the chart below, which shows the five year treasury yield in amber, now at 2.64%, and the CDX 5y High Yield Spread in white.  In 2016 the five-year yield was over 100 bps lower than it is now (1.60 vs 2.65).  So while the spread is a bit over 100 bps beneath the crisis level in 2016, actual borrowing costs for debt rollover are about the same, in the context of a slowing economy.  Data from the St Louis Fed shows the same picture, US Corp BBB Effective Yield topped a bit below 4.6% in 2016, fell to 3.25% in the middle of that year, and is now 4.7%.  That is, more cash flow is needed to service debts, in an economy where earnings are likely to be challenged.  We NEED inflation, not in terms of wage gains, but in terms of pricing power.  However, that’s not too likely.  “It was a disappointing Christmas, on many levels.” (Vinnie Antonelli). *

This week, near Eurodollar one-year calendars all made significant new lows.  The near part of the Eurodollar strip is telling this story:  ‘The early 2018 tax cut and repatriation provided the economy with a sugar high.  Economic vigor was stolen from the future, and the future is now.  Fed eases are coming.’  The lowest one year spread is Dec’19/Dec’20 which settled -16, having traded as low as -19.5.  This is now the 4th to 8th contract spread, and as I mentioned last week, at the end of 1994 this spread traded minus 23 and at the end of 2006, it traded -26.5.  So we approached historic lows.  The nearest one-year spread is now March’19 to March’20, which plunged 12 bps on the week to -3.5.  However, in FF’s, the Jan’19/Jan’20 spread settled +11.5, still clinging to the idea of a hike in 2019 rather than an ease.

Looking further out on the ED curve is somewhat interesting.  While talk of inversion in treasuries was rampant, I’ve previously noted that the first inversion to occur was in Eurodollars.  The chart below tells the story.  The red to gold pack spread, 2nd year forward to 5th year forward, inverted in the summer.  But look what happened this week as the Dec’19 contract dropped out of the reds.  Red/gold broke a two year trend line and closed POSITIVE 13.5.  The curve steepens when the market thinks the Fed will start easing.  Is the red/gold pack spread an early indicator?  Probably. 


There’s one other chart I want to show, though this note is already a bit long.  While most stock indexes, outside of utilities, are significantly lower on the year, I like to look at a chart of stocks as compared to commodities once in a while.  The chart below shows SPX priced in terms of the BBG Commodity Index.  Still up on the year, but it has broken a four-year trend in spite of the plunge in Crude Oil.   

Finally, one of the most important events of the week might have been the resignation of General Mattis.  The lack of adult-supervision at the White House with both Kelly and Mattis gone is a big concern.  Friday’s comments by Peter Navarro that China needs a “full overhaul of trade practices” and is “…trying to steal the future of Japan, the US and Europe by going after our technology” is a case in point. Talk that Trump wants to fire Powell (denied by Mnuchin) is another.   


“Business!” cried the ghost, wringing its hands again. “Mankind was my business.  The common welfare was my business; charity, mercy, forbearance, and benevolence, were, all, my business.  The dealings of my trade were but a drop of water in the comprehensive ocean of my business.”

-Charles Dickens, A Christmas Carol


Feb/April FF spread settled 4.0, a new low, -3.5 on the week. May/July settled 3.5 and August/October barely positive at 0.5.  Jan’19/Jan’20 FF 11.5 and April’19/April’20 which is just past the march FOMC, settled 3.5.  The Fed has two hikes penciled in for 2019.  Interest rate futures are an eraser. 

The main takeaways are this: even with a big plunge in stocks on Friday, fixed income didn’t have much of a move.  Supply concerns are a looming overhang.  We’re going into a holiday week with thin conditions.  Anything can happen

12/14/2018 12/21/2018 chg
UST 2Y 273.0 264.1 -8.9
UST 5Y 272.6 264.0 -8.6
UST 10Y 288.6 279.0 -9.6
UST 30Y 314.1 302.7 -11.4
GERM 2Y -60.9 -60.2 0.7
GERM 10Y 25.2 25.0 -0.2
JPN 30Y 77.5 74.2 -3.3
EURO$ H9/H0 8.5 -3.5 -12.0
EURO$ H0/H1 -9.5 -11.0 -1.5
EUR 113.09 113.70 0.61
CRUDE (1st cont) 51.20 45.59 -5.61
SPX 2599.95 2416.62 -183.33
VIX 21.63 30.11 8.48

Posted on December 23, 2018 at 8:41 am by alexmanzara · Permalink
In: Eurodollar Options

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