What is two plus two?

Sept 1, 2019 – Weekly Comment

Greenspan told this joke. ‘Three patients at a mental institution wanted to be released.  The head psychiatrist gave them a simple test. What is two plus two?  The first patient said, Five.  The second, Wednesday.  The third got it right.  FOUR, he said.  The first two patients were returned to their ward.  Patient three was free to go.

By the way, asked the doc as the man was leaving, how did you know the answer?
Easy, said the patient.  I just added five plus Wednesday.

That’s an excerpt from a Washington Post profile of Greenspan on March 24, 1997, ‘The Shy Wizard of Money’, when his reputation was at its pinnacle. 

Key aides to President-elect Bill Clinton are considering an unusual strategy to attack the budget deficit, in which the Federal Reserve Board would reduce interest rates while the White House pursues a program of spending cuts and tax increases. –LA Times, Jan 18, 1993, Deal With Fed to Cut Rates Studied

The debates, before and since, over the issue of our money standard have mirrored the deliberations on the manner in which we have chosen to govern ourselves, and, perhaps more fundamentally, debates on the basic values that should govern our society.

–Alan Greenspan, Dec 1996 speech, ‘The Challenge of Central Banking in a Democratic Society’ which is now referred to as the “irrational exuberance” speech.  LINK at bottom, great read.


August 2019 was a ‘five plus Wednesday’ month.  A couple of weeks ago I outlined a few of the extraordinary events: $17 trillion in negative yields globally, the plunge in US yields, 2/10 inversion, GE accused of accounting fraud, continued Hong Kong protests, Argentina meltdown, Trump’s suggestion to buy Greenland, US Treasury considering selling 100 year bonds. 

What else could happen? 1) This incendiary tweet: “…My only question is, who is our bigger enemy, Jay Powell or Chairman Xi?”  which occurred the week previous to last.  2) Carney’s (BOE) suggestion at Jackson Hole that USD as reserve currency could be replaced by something like Libra. 

However, William Dudley, the former head of the NY Fed took the cake on Tuesday with a Bloomberg opinion piece including these shocking lines; “If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”  More specifically, “Trump’s reelection arguably presents a threat to the US and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives.”  Wow.

The Dudley piece was simply astonishing. However, since then, so much has been written about it that I can’t possibly add more.  I will only note that the Fed officially distanced itself, releasing a succinct statement: “The Federal Reserve’s policy decisions are guided solely by its congressional mandate to maintain price stability and maximum employment.  Political considerations play absolutely no role.”

Dudley, of course, has now made the Fed’s job that much more difficult.  But let’s return to political influence and cooperation between the Fed and the administration, highlighted in the second quote above.  At President Clinton’s first State of the Union address in 1993, Fed Chairman Alan Greenspan was seated between first and second ladies Hillary Clinton and Tipper Gore.  (He’ll never get those few hours back…).  A Washington Post piece from March 21, 1993 said, “Simply by sitting there, he appeared to be sacrificing a slice of the Fed’s vaunted independence.” The article further added, “But his presence there was no mistake; He had been briefed on the major points of the Clinton economic plan and he was willing publicly to support its basic goal of reducing future federal budget deficits.”   

It’s an incredible contrast to today’s relationship between the Federal Reserve and the Administration.  I’ve re-written the LA Times quote above to capture the absurdity of the current environment:

Donald J Trump is pursuing an unusual strategy of attacking Chairman Powell, in order to force the Federal Reserve Board to reduce interest rates while the White House pursues a program of spending and tariff increases and tax cuts.

If that had been written as a hypothetical outcome at the beginning of Trump’s tenure, it would have been reasonable to conclude it would end in disaster.   But here we are, with historically low unemployment, steady growth, and low inflation.  Five plus Wednesday.  The Fed’s mission and independence is now openly called into question at the highest level. The current climate hearkens back to Greenspan’s musings on the basic values that should govern our country.  It is a fluid period where policies of the central bank are politically interwoven with the nation as a whole.  Increases in the US budget deficit are masking structural problems. The Fed will be called upon for monetization.

I’ve often observed that markets test new central bank chiefs.  With Volcker it was withering criticism as he crushed inflation with high rates.   With Greenspan it came early, with the brief stock market crash of 1987.  Bernanke of course, faced the subprime crisis and great recession.  Yellen pretty much got off scot-free, but Powell is paying double now.  Draghi became head of the ECB in June 2011, and, to stem the run on weak euro-countries’ bonds and save the euro, on July 26, 2012, said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.  And believe me, it will be enough.”  Powell is under constant siege and now Draghi is handing off the ECB to Christine Lagarde who starts on Nov 1.  She has a steady hand and deft political instincts.  She’ll need them.  Just as a point of reference, in 2012 Spain and Italy tens were north of 6%.  Last week Italy tens traded sub 1%. On Thursday Lagarde said, “I don’t believe that the ECB has hit the effective lower bound on policy rates.”    

What’s the point?  The economic environment is becoming more surreal by the day.  Many challenges lie ahead, relating to global trade activity and practices, central bank policies and independence, and the international monetary order.   Specific flash points include Brexit, Hong Kong, Iran, Japan/S Korea and of course, US/China.

For now, these global stresses are resulting in demand for dollars.  This is apparent in the chart below.  DXY (not shown) closed at the high of 2019 this week, but remains below the high set at the end of 2016 which corresponded to tighter financial conditions across an array of measures.  This was the time of both crude oil and EM coming under severe pressure, along with widening corporate spreads. However, the Fed’s Broad Trade Weighted USD index (TWDI) which includes a wider range of currencies, has not only exceeded the high of 2016, it has now eclipsed the high set in 2002, currently marking just above 130.    

Dollar policy is under the purview of Treasury, not the Fed, but USD strength signals a demand for liquidity and presents a risk to US economic outcomes.  It’s going to be Mnuchin’s turn to have his feet held to the fire, because it may become apparent that USD strength is choking the world, but the Fed, which could help by cutting 50 in Sept and guiding lower, may be loathe to make any moves outside the lines.  Vulnerabllities have risen.

This coming week culminates with the employment report Friday morning, NFP expected 160k, followed by a speech on the economic outlook by Chairman Powell, which will be the last Fed speech prior to the Sept 18 FOMC.  Powell will likely re-emphasize that the Fed operates solely within the constraints of price stability and full employment.  The past has shown that when crises erupt, central banks must spontaneously pursue unorthodox policies.  Will Powell have that flexibility?   

Tuesday and Thursday will feature ISM data, Mfg expected 51.2 and Services 46.8.  US/China tariffs went into effect Sept 1.  China’s Mfg PMI released this weekend continues to weaken, at 49.5 vs 49.7 in July.  Macau’s gaiming revenues fell 8.6% in August.


Below is a chart of EDU21, green Sept, which closed Friday at the peak on the euro$ curve at 98.860 or 1.14%.  The highest contract had been EDH21, but it has moved further back in time, indicating that economic malaise may be in our future longer than previoulsy thought.  I’ve marked the last three FOMC meetings which resulted in actual changes in the FF target.

From Sept 26, 2018 FOMC

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2 to 2-1/4 percent.

From Dec 19, 2018 FOMC announcement:
In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2-1/4 to 2‑1/2 percent.  NO DISSENT

From July 31, 2019 FOMC announcement:

In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4 percent.  DISSENT Rosengren and George; wanted to maintain.

So in the period of just under one year, starting and ending with the FF target at 2.0 to 2.25%, EDU21 has rallied a stunning 200 bps from 96.86 to 98.86!!  Obviously, there is forward roll, but the constant maturity ten year treasury yield over this period dropped over 150 bps, from 3.05% to 1.50%. 

I continue to think the odds of a 50 bp cut in September are being under-priced, but it would take a jolt from equity markets to force the issue.  October 2019 FF contract settled 98.155 or 1.845%, which is 28.5 from the current EFFR or 2.13%.  There is just 3.5 bps of ‘premium’ leaning towards 50.

November euro$ midcurve options expire 15-November, thus encompassing the ECB changeover, the Oct 31 Brexit deadline and the Oct 30 FOMC.  I would expect this expiration to become more active as Oct mids expire 11-Oct. 

8/23/2019 8/30/2019 chg
UST 2Y 150.3 150.2 -0.1
UST 5Y 139.7 138.5 -1.2
UST 10Y 152.3 150.3 -2.0
UST 30Y 201.8 196.8 -5.0
GERM 2Y -89.2 -92.7 -3.5
GERM 10Y -67.5 -70.0 -2.5
JPN 30Y 20.4 14.6 -5.8
EURO$ Z9/Z0 -50.5 -60.0 -9.5
EURO$ Z0/Z1 -5.5 -9.5 -4.0
EUR 111.45 109.91 -1.54
CRUDE (1st cont) 54.17 55.10 0.93
SPX 2847.11 2926.46 79.35
VIX 19.87 18.98 -0.89






Posted on September 1, 2019 at 9:41 am by alexmanzara · Permalink
In: Eurodollar Options

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