The Unexpectable

April 12, 2020- Weekly Comment

Early Thursday morning prior to expiration, April 3-month eurodollar, EDJ0, was trading 98.72 or 1.28%.  Then, three-month Libor set at 1.21888%, down nine bps from the previous day’s setting, so the EDJ0 contract settled at 98.7811.  There were 549,312 contracts open in EDJ0, so a 6 bp move equates to a transfer of $82,396,800 from shorts to longs.  Within a couple of hours of expiry, the Fed announced a series of massive measures to stabilize markets. 

In the big picture, $82 million is a drop in the bucket.  Indeed, the June euro$ (EDM0) which has three times more open interest than April had, rose 8 bps on the day.  It would appear that those banks setting the libor rate had a pretty good idea of the upcoming Fed announcement. It’s not really worth the effort to launch into a discussion of market integrity and libor-rigging.  My point a couple of weeks ago was that a decline in the libor/ois spread to more reasonable levels would be a key metric to determine whether markets were on the mend.  So here’s a graph of the midpoint of the FF target (FDTRMID <index>) with three month libor.  The amber line is the midpoint of FF and the white line is 3m libor.  The lower panel shows the spread.  Slow improvement.

3m libor white/ FF target amber


You can see from the above chart that the low in three month libor after the first hike was 74.050 bps on March 12.  The high was at the very end of the quarter on March 31 at 1.45050%, exactly 71 bps higher, which occurred after the Fed slashed to a target of zero to 25 bps.  In many ways, this price action underscores why the Fed may not want to pursue negative rates; just going to zero produces many market distortions, clearly reflected by the jump in libor.  In any case, the Fed’s unlimited support for munis, corporates, small business etc announced on Thursday should continue to force the libor rate lower.  On Thursday, the May ED contract settled 99.265 or 73.5 bps, essentially matching the March 12 low setting on libor.  The EDM0 contract, which posted a low of 99.305 last week on Wednesday, and a previous low on March 19 of 99.27 should hold these levels going forward, and will likely trade above 9950 given the Fed’s extraordinary support measures.

Forward euro$ straddles indicate the same thing, perhaps with more complacency than is prudent.  For example EDU0 99.625^ settled 21.5 vs 99.605 and EDZ0 99.625^ settled 25.0 vs 99.635.  The market is comfortably projecting 3m libor around 35 to 40 bps.  Dec 31 this year is on Thursday, so the turn will be four days.  There will likely be a fair amount of demand for EDZ0 puts, which are currently cheap in my opinion.    

CPI released on Friday showed a monthly decline of -0.4%.  No surprise, implosion of demand should clearly lead to lower prices over the short term. I don’t know how the BLS adjusts for a given level of rent on commercial space when a significant percentage of lessees have stopped paying.  I suppose there’s a lag as prices adjust lower over time.   Many prices are likely to decline as supply and demand factors (eventually) determine a clearing price.  This process may take a year.  But even if the general price level is lower in one year, forward prices will impact inflation.  Over time, pressures on the long end of the market should be unmistakable both due to supply and due to general increases in the level of prices, which will, of course, come from a lower base.  The Fed will clearly be the lender to the treasury.

Powell repeatedly said on Thursday that the Fed’s actions were “loans”, that the Fed cannot buy assets.  And in a BBG interview Danial Tarullo, formerly on the Fed board, said that in the GFC the Fed lost no money on loans.  While some had failed, the interest paid on others completely absorbed the smaller losses.  It’s very hard to believe that will be the same case this time around.  The Fed is backstopped by the treasury.  The treasury is backstopped by the power of taxation.  The government was already running a huge deficit which is now simply gargantuan.  Current taxation wasn’t close to closing the gap prior to the pandemic, now the hole is a gaping abyss.  Additionally, the rest of the world is also deficit spending to buffer the virus crisis.  Who will buy the additional trillions in debt?  The Fed.  But don’t worry, the Fed is backstopped by the Treasury.  The entire system has become circularly meaningless. 

It was previous actions by the Fed and Federal government that spurred the public to warmly embrace risk and financial engineering without regard to possible consequences.  Now the panels have convened to save financial markets because those markets now ARE the economy, as much as Powell tried (early on) to separate the two.  Nothing is new.  I always refer back to Reminiscences of a Stock Operator to assure myself of that.  The background of the passage I quote below relates to Lawrence Livingston’s WW1 coffee position, in which he had amassed a large long position at prices that were below the pre-war levels.  “I was and am as keen as anybody against the profiteer in the necessities of life, but at the time the Price Fixing Committee made their ruling on coffee, all other commodities were selling from 250 to 400 per cent above pre-war prices while raw coffee was actually below the average prevailing for some years before the war…  The price was bound to advance; and the reason for that was not the operations of conscienceless speculators, but the dwindling surplus for which the diminishing importations were responsible…”

Coming sure and fast, that profit of millions! But it never reached me. No; it wasn’t sidetracked by a sudden change in conditions. The market did not experience an abrupt reversal of form. Coffee did not pour into the country. What happened? The unexpectable! What had never happened in anybody’s experience; what I therefore had no reason to guard against. I added a new one to the long list of hazards of speculation that I must always keep before me. It was simply that the fellows who had sold me the coffee, the shorts, knew what was in store for them, and in their efforts to squirm out of the position into which they had sold themselves, devised a new way of welshing. They rushed to Washington for help, and got it.  

See crude oil.

4/3/2020 4/9/2020 chg
UST 2Y 20.9 22.3 1.4
UST 5Y 36.4 40.8 4.4
UST 10Y 59.0 72.2 13.2
UST 30Y 122.0 134.8 12.8
GERM 2Y -66.2 -62.0 4.2
GERM 10Y -44.1 -34.7 9.4
JPN 30Y 38.6 44.9 6.3
EURO$ M0/M1 -24.0 -26.0 -2.0
EURO$ M1/M2 8.5 12.5 4.0
EUR 108.10 109.43 1.33
CRUDE (1st cont) 28.34 22.76 -5.58
SPX 2488.65 2789.82 301.17 12.1%
VIX 46.80 41.67 -5.13

Posted on April 12, 2020 at 9:39 am by alexmanzara · Permalink
In: Eurodollar Options

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