What does Kudlow know?

March 31, 2019 – Weekly

In November the US ten year yield reached a high of 3.20%.  Now it’s 2.40, a drop of 80 bps.  In October, China’s ten year yield was 3.70, now 3.07, a drop of 63 bps.  Japan’s 30 yr yield was 95 bps on Oct 4, now  50, a drop of 45 bps.  On Oct 4, the German bund yield was 56, now -7, a drop of 63 bps.  On Jan 4, the BBB spread hit a high of 204 bps.  Now 162, a decrease of 42 bps. Since early November, EDM21 has rallied over 100 bps.  SPX gained over 13% in Q1, while the Shanghai Comp was up a sizzling 24%. These changes represent a huge easing in financial conditions. As Robert Smith of the Financial Times notes, “The amount of government debt with negative yields rose back above the $10tn mark this week, as central banks abandoned plans to tighten monetary policy.”

On Friday, chief economic advisor Larry Kudlow appeared on CNBC and said the Fed should ease by 50 bps.  He said the administration respects the Fed’s independence but doesn’t want monetary policy to “jeopardize” (a word he used repeatedly) the economic recovery.  Hey Larry, the bond markets have already eased by over 50 bps since the December meeting.  Is it appropriate to cut short rates when the supposed last piece of the inflation puzzle, wages, are accelerating?  Kudlow, and everyone else, knows that monetary (and fiscal) policies operate with a lag, normally cited at around six months.  Short term interest rate markets are more or less pricing in one cut in the FF target by the end of the year, with the January 2020 FF contract settling Friday at 9785.0 or 2.15%, exactly ¼% below the current Fed Effective of 2.40%.  The easing steps taken by China since the start of the year appear to have taken hold (faster than six months, but perhaps distorted in part by the Lunar New Year) as the official PMI rose to 50.5 in March from last month’s three year low print of 49.2.  “Factory output grew at its fastest pace in six months in March… It rose to 52.7 from February’s 49.5, the highest level since Sept 2018.” (RTRS).

According to a piece in ZH citing Chief Investment Strategist Michael Hartnett from BAML, there are five big data points to watch this week to get a sense of Q2: 

  1. March China Mfg New Orders PMI (51.4 actual, a five month high).
  2. March S Korea yoy exports (-11.1 last)
  3. February US Retail Sales (Monday, expected +0.3% MoM)
  4. March US Mfg ISM (Monday, expected 54.5 from 54.2 last)
  5. February German factory orders MoM

I would add the US employment data, which is released this Friday with NFP expected 175k and YoY Average Hourly Earnings again at 3.4%. 

As mentioned, China’s data came out strong.  S Korea exports are out Monday, last at -11.1% yoy vs an expected -10.8%.  Often cited as a global “canary in the coalmine” this bird’s tweets have fallen silent.  “It marked the third straight month of decrease in outbound shipments and the steepest since April 2016” (Trading Economics).  The YoY declines are accelerating, with the last three months -1.3%, -5.9% and -11.1%.  Of particular note, “Exports to China, S K’s top trading partner, contracted 17.4%…”  Here’s a chart from the St Louis Fed’s FRED site.  Although it doesn’t show last month’s steep drop, it gives a bit of historic perspective, with a huge plunge during the GFC.  It also shows the sharp drop in 2015 to early 2016, coinciding with the evisceration of oil prices and emerging markets.  Note that these drops preceded the low yields in global bond markets which occurred in mid-2016. 

YoY seasonally adjusted growth rate, South Korea Exports

One data point that doesn’t indicate looser financial conditions is the dollar index.  As can be seen from the chart below, it has tested the 61.8% retracement of the large decline from the beginning of 2017 to Q1 2018.  That level is 97.87 vs 97.25 currently.  In general the stronger dollar portends global disinflationary pressure.   In late 2014, the dollar index had a strong rally, while WTI crude fell from over $100/bbl to the low 40’s.  As DXY then retraced lower in Q1 2015, WTI bounced to just over $60, and then plunged to a new low around $30 in Q1 2016.  We’re currently at new ytd highs in oil (CLK9 60.14), right at the level seen at the bounce in early 2015.  If price action continues to echo 2015, then oil will have some tough sledding ahead.  By the way, the late 2016 run-up in DXY coincided with the plunge in oil, with the new high in DXY preceding new lows in WTI by a month or so.  Of course late 2015 was a rough time for US equities as well, and for EM.  

Perhaps that’s why Kudlow is (uncomfortably) trying to influence the Fed into more immediate rate cuts than are being priced by the market, even as wage pressures are building.  Because if the dollar starts to strengthen above 97.87 to 98.00, the next stop will probably be 100, with associated moves lower in oil, EM, and *gasp* SPX.  Note that ytd gains in the EEM etf have been solid at 11.7% but have lagged other markets.  At 42.92, it’s not much of a retrace from the tax-cut inspired highs of 52 in early 2018 to the low late last year of 38.

5 year chart of DXY (dollar index)

So why would the administration keep the pressure on the Fed?  It’s too early to juice the economy for the next election.  But parliamentary elections in Europe are in May, and Draghi is gone at the end of October.  Perhaps it’s a race to the bottom in FX. 

I don’t want to cherry pick price declines, but the plunge in Palladium (PAM9) from last week’s high of 1577 to a low close of 1309 is breath-taking, even after the last six month monster rally from 850.  Gold (GCM9) dropped $36 this week, and May Corn fell a whopping 23 cents (6%) from Monday’s high settle of 379 ¾ to Friday’s 356 ½.  New lows in the aftermath of the grain report in spite of massive losses in farmland due to flooding. Lumber hit $659 in Q2 2018, and is now $360, back to levels from early 2017.  OK.  So maybe I am cherry-picking.  But still.

This is already a long note, so I won’t bother with the other data points being released this week.  However, I do have to mention Friday’s trade action in Eurodollar options.  Mid-session, one player came in and “iinhaled” long dated 45 delta calls.  EDM21 9800c traded up to 33.0, with an increase in open interest (new buys) of 29.5k.  Settled 31.75 vs 9787.0.  EDU21 9800c traded up to 37.5, with an increase in open interest of 53k.  Settled 34.0 vs 9784.5.   Just before these buys, EDH20 9737.5 calls were liquidated/sold in size of 22k at 37.5 to 36.5.  These are now 76 delta, in-the-money calls, originally bought on Jan 11 at a premium of around 25.0; EDH20 settled that day at 9740.0   So it’s a LARGE roll-up of calls, net 60k contracts.  As a bit more background, on Jan 11th, a Friday, very late in the session someone came in and bought over 200k long-dated atm calls.  He single-handedly ran prices up on aggressive buys, as filling brokers in the pit raced each other to get their orders filled in thin conditions; the orders had been split among several groups.  This time, the buying was done much earlier, mostly through one filling floor broker.  In mid-January after these buys, yields edged higher, but then the rally ensued.

While there was huge buying of EDZ9 9750/9737/9725/9712 put condors over the past week (from 3.5 to 5.25 recently in size >400k), the upside still has proponents.  Put skew has been hammered, for example EDZ9 9725 puts, with a supposed -0.15 delta, went up 0.25 to 2.25 on Friday, rather than the 0.75 indicated by the delta as EDZ9 fell 5 bps.    

The powers that be keep trying to fight deflation with unconventional tools while making sure asset prices won’t go down.  But lower rates and QE keep zombie companies on life support and don’t allow the market to effectively clear, thus stifling pricing power and spurring investment flows into financial assets with dubious prospects of returns (Lyft).  But now wage increases are increasingly a headwind on corporate profitability.    

Posted on March 31, 2019 at 1:28 pm by alexmanzara · Permalink
In: Eurodollar Options

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