The risk of delay

April 25, 2021 -Weekly comment

“We do see risks of delaying a return to neutral monetary policy.  These risks can lead to the need for a more significant rate hike in the future, and I think we all want to avoid that.”  Russian Central Bank Governor Elvira Nabiullina, after the CB raised its key rate by 50 bps to 5% on Friday.  Consumer inflation is running at about 6%.

On Wednesday Bank of Canada announced scaled back bond buying and accelerated the timetable for a possible rate increase, due in part to price pressures.

On Friday Mohamed El-Erian was interviewed by Maria Bartiromo and he said the Fed is now “outcome based”, i.e. they won’t try to get ahead of projections.  Because monetary policy operates with a lag, that policy presents a risk. 

It’s worth taking a look at the Kansas City Fed’s surveys on manufacturing and services last week:

Tenth District manufacturing activity expanded further with the highest monthly composite reading in survey history, and expectations for future activity increased considerably. The index of prices paid for raw materials compared to a month ago also reached the highest level in survey history. In addition, finished goods prices expanded more from a month ago and a year ago. Materials price expectations for district firms over the next six months continued to rise, and many firms also expect higher finished goods prices.

Tenth District services activity continued to rise from a month ago and a year ago, and activity was expected to increase further over the next six months.. The pace of growth for input prices remained near record high levels, and selling prices also expanded considerably to a record posting (since survey inception in 2014). Additionally, firms expected input and selling prices to increase over the next six months.

The FOMC meets this week Wednesday and is expected to re-affirm guidance on asset purchases and holding the Fed Fund target at 0-0.25%.  Core yoy PCE prices are released Friday and expected at 1.8% (which is low compared to most other measures).  Powell continues to emphasize employment and wages for the disenfranchised, but here again it’s worth referring to the KC Fed.  Below are selected comments from the manufacturing survey;

“It is very difficult to handle the increased business with supply chain issues across all materials and finding anyone who wants to work. The federal government has incentivized people to stay home and not be productive.”

“Stimulus and increased unemployment money are wrecking the labor pool. Lower level employees are quitting to make just as much not working.”

“Entry level pay will need to be increased. This will create pressure on all other positions.”

With respect to supply chain problems, there are now frequent references to what is belatedly recognized as under-investment in productive capabilities.  Obviously COVID threw some plans onto the shelf, but the trend toward financial engineering led to a lack of true investment.  Obviously lumber is not a good proxy for US inflation pressures (even though the price of the near futures contract has more than doubled since the start of the year).  In the US we expect products to always be available and ready to be shipped immediately.   Think about lumber: “The time it takes for a lumber forest to mature depends on the type of lumber product being cultivated.  Birch for chipboard or paper can be thinned for the first time after 10 or 20 years. A forest of red oak grown for lumber will be ready for harvesting in 52 years…”  Not everything is instant.  It may take years to smooth out the supply chain.  By the way, soybeans are up over 50% since the start of the year.

Now for a couple of comments on financial market inflation.  April to date SPX is up nearly 5%.  That’s with Biden proposing a huge increase in the capital gains tax last week.  For now, strong earnings, Fed’l government deficit spending, and Fed monetary largesse are dominant factors.  In terms of magnitude, an appropriate comparison might be late 2017 into 2018.  Back then it was all about Trump’s tax cut program in terms of stimulus.  Congress passed the bill on Dec 20, 2017.  “Most of the changes introduced by the bill went into effect on January 1, 2018 and did not affect 2017 taxes.”  From December 20, 2017 to January 26, 2018 SPX rose about 7.2%.  Currently, in the past 18 sessions since the March 24 dip, SPX is up 7.6%.  For a slightly longer comparable timeframe, from an August dip in 2017 to the late Jan high, SPX soared nearly 19%.  Over the same length of time, from late October 2020 until now, SPX is up a blistering 30%.

In 2018, from the high on Jan 26, the market dropped over 10% in the next eight sessions.  At the high on Jan 26, 2018, SPX was 12.7% above the 200 DMA and it reverted to the 200 DMA on Feb 9.  Currently SPX is 15% above the 200 DMA.  I don’t think I have ever seen as much of an acceleration in the 200 DMA over a four month period as we’ve seen from mid-December until now.  Of course, in 2018 the Fed was leaning against the more robust economic backdrop brought about by fiscal policies.  Currently the Fed is aiding and abetting what many consider to be irresponsible fiscal expansion.

 OTHER MARKET THOUGHTS/ TRADES

This week the Treasury auctions 2, 5 and 7 year notes.  The seven year has been a problem area, but with a yield over 1.25%, even though significantly negative in real terms. auctions shouldn’t be an issue.  FOMC Wednesday. Personal Income, Spending and Core Price Deflator on Friday. 

Bitcoin has been the big loser over the past couple of weeks, shedding almost a quarter of its value from the April 14 high of 64870.  Similarly, the SPACs have been spanked since late February, with SPAK (the SPAC etf) down 27% since then.  Peripheral markets are showing weakness. 

Over the week, treasury yields and the Eurodollar curve were little changed.  However, the theme of buying puts and selling calls saw pockets of renewed interest.  As an example, 3EU 9800/9900 risk reversal traded 0.5 and 1.0 for the put, with futures 9853 to 9855.  Both strikes added around 40k in terms of open interest.  Settlements on Friday were EDU4 9851.5, 9800p 7.5 and 9900c 4.75, so 2.75 for the put.  There were some similar trades closer in on the curve, on red midcurves.  For those inclined to believe that inflation is likely to be an intransient problem (as I do), the core questions are where on the curve to be short, and, if equities are at risk of a large retracement, will bonds rally?  The first question requires assumptions about when/if the Fed is forced to move early.  On the second part, consider this snippet from rates strategist Rishi Mishra: “That – policies that shift the balance back towards labor from capital – that will be the ultimate sell USTs, sell SPX trade…”  He’s referring to the capital gains tax increase proposal, but the point is that we might be on the cusp of a shift where both bonds and stocks perform poorly.  Given the fact that greens to blues (3rd to 4th year) are the steepest part of the euro$ curve at 59 bps, I would tend to favor puts on the front three greens, EDM23, U23 and Z23.  Of course, this is also the period of time that encompasses the libor transition, but if the Fed signals rate hikes, a return to 2% or higher FF target could easily occur by mid-2023.   

Below is an updated chart of SPX divided by the BBG Commodity Index.  It has been nothing but SPX outperformance since the start of QE.  However, the most recent commodity surge has caused this ratio to move sideways

4/16/20214/23/2021chg
UST 2Y16.115.7-0.4
UST 5Y81.981.3-0.6
UST 10Y156.9156.5-0.4
UST 30Y226.0225.0-1.0
GERM 2Y-69.0-69.00.0
GERM 10Y-26.2-25.70.5
JPN 30Y65.363.6-1.7
CHINA 10Y316.0317.51.5
EURO$ M1/M28.08.50.5
EURO$ M2/M339.039.50.5
EURO$ M3/M467.068.01.0
EUR119.86120.991.13
CRUDE (active)63.1962.14-1.05
SPX4185.474180.17-5.30-0.1%
VIX16.2517.331.08

https://www.kansascityfed.org/surveys/manufacturing-survey/tenth-district-manufacturing-activity-expanded-further/

Posted on April 25, 2021 at 12:18 pm by alexmanzara · Permalink
In: Eurodollar Options

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