January 15, 2017. Be Careful Brethren!
Early morning, April four
Shot rings out in the Memphis sky.
Free at last, they took your life
They could not take your pride.- U2
https://www.youtube.com/watch?v=O6NAKgv4ALg
There are a lot of inspirational Martin Luther King quotes, but in reviewing them I was struck, not by the most famous and powerful ones, but by some that seem to have foreshadowed our present condition. Maybe it’s simply that they’re timeless.
The function of education is to teach one to think intensively and to think critically. Intelligence plus character – that is the goal of true education.
“If we are not careful, our colleges will produce a group of close-minded, unscientific, illogical propagandists, consumed with immoral acts. Be careful, ‘brethren!’ Be careful, teachers!”
–Above from ‘The Purpose of Education’, Morehouse College Student Paper, 1947
Currently, these quotes relate to the firestorm surrounding fake news. I learned all I need to know about fake news in the markets. One of the lessons that always stuck with me was when I was a kid on the CBOT floor in the bonds. This was of course, in the time when ‘news’ was much more valuable. There were no chat programs that zapped info from a website instantaneously to the entire globe. So when you heard a rumor, you punched the direct phone line of a trader. Which I did once with Mel Swanborn, a veteran gov’t bond dealer. Of course I can’t remember the particular piece of information that I was convinced was so valuable, but I vividly remember Mel’s reaction. And it wasn’t the “Buy 200” which I was expecting. It was this, “Where did you hear that?” “How long ago?” “How did that guy hear it?” “Who’s he with?” Mel knew exactly what he was doing. Now more than ever it’s necessary for individuals to critically judge the veracity of news.
It’s somewhat ironic I suppose that MLK day, now known as a Day of Service, is in the same week as the inauguration. Financial markets greeted Trump’s election with jubilation, but likely overshot, and uncertainty about stimulus plans seems to be creeping in around the edges. For me, that’s most apparent with respect to the Eurodollar curve. But I’ll veer off course for a minute just to mention something that captured my attention this week, and that’s significant buying of Feb VIX calls. As I cited during the week, the strikes are primarily 21 and 22 calls with open positions of 247k and 241k (Friday there was a buyer of 147k Feb VIX 21 calls for $0.50). The last time VIX visited 22 was right around the election: ‘oh no! Trump might win’. Perhaps this time it will be the reality of ‘Oh no! Trump’s being sworn in.’ In any case, I don’t know the exact rationale for the trade, but with Jan VIX at 12.175 and Feb 14.225, there’s significant negative roll for calls to overcome. On the other hand, I can see selling July VIX against long Feb calls for a cheap way to play for the possibility of a risk event, as July should roll down 60 cents to June’s level if nothing occurs. What could spark an event to slingshot near contracts to a premium? China’s President Xi addresses Davos Tuesday, Fed’s Yellen speaks on the goals of monetary policy Wednesday (with Q&A) and the inauguration is Friday. My personal opinion is that China is not bluffing about its ‘One China’ at all costs policy.
Back to interest rates. First, note that net changes on the week were again small. There continues to be significant buying of April ED 9862/9850 put spreads, with open interest in those two strikes ballooning to 246k and 235k. With EDZ6 having expired essentially on the 9900 strike, there are plenty of trades targeting 25 bp increment moves once per quarter, i.e. EDH7 at 9875, EDM7 at 9850 and EDU7 9825, as compared to Friday’s settles of 9892.5 in H7, 9876.5 in M7 and 9863.0 in U7. Clearly many of these trades are binary and dependent on an initial hike in March, which likely heightens interest in Yellen’s comments on Wednesday afternoon. Of course, some clues might be taken from Bernanke’s latest blog regarding how the Fed might handicap upside risks of fiscal policy embedded in Trump’s vision:
Regarding timing: No one knows at this point how long Congress will take to pass legislation—fiscal changes can be both complex and contentious. And, once passed, fiscal programs can take a while to have their effect (infrastructure programs, for example, can take a number of years to build out). Consequently, the impact of new fiscal measures may be felt in 2018 or 2019, rather than this year. Of course, that gives the Fed more time to assess the program and determine an appropriate response.
It seems to me as if the Fed will likely err on the side of caution, as usual. That’s one of the reasons that I am quite surprised by the flattening of the Eurodollar curve, which has occurred consistently since the December rate hike. As an example, the red/gold Eurodollar pack spread (2nd to 5th year) closed the week on the low at 71 which is exactly the halfway back point from the Sept 27 low of 41 to the Dec 12 high of 101.5. (Currently 30 off the high). At the same time, measures of inflation expectations seem to be holding relatively near the highs spurred by Trump’s win.
For example, the chart above is the spread between the ten year inflation indexed note and the ten year treasury yield (white line). This spread is now at its recent high above 200 bps, 80 higher than the start of 2016 which was related to the plunge in oil, and about 30 bps higher than pre-election. I’ve overlaid the dollar index in green. Previously a firming dollar (mid-2014 to mid-2015) was associated with a drop in inflation expectations, a relationship which appears to have diminished significantly.
The USD 5y5y inflation swap forward was between 190 and 200 last July and August, vaulted to 250 after the election, printed over 260 in Jan, and is now 241. The EUR 5y5y inflation swap forward was as low as 125 in September and has had an orderly 50 bp rally to 174 currently. The Bloomberg Commodity index is up over 13% yoy, and the University of Michigan’s inflation expectation index for the next year popped up from a low of 2.2% to 2.6%. Underlying economic data have improved both in the US and Europe.
While the 2/10 treasury spread hasn’t had the same magnitude decline as ED calendar spreads, it’s still down 16 bps from the Dec 22 high (spread currently 119.6). The point is this: the back end of the curve has been flattening in the face of inflation signals that are becoming somewhat more compelling. With respect to Bernanke’s note that fiscal measures might not really take hold until 2018 to 2019 – which might then elicit a more forceful Fed response – consider that the reds to the greens (year 2018 contracts compared to year 2019) are only 34 bps on average, or less than 1.5 hikes.
The treasury market is still subject to flight to quality bursts, so using options to play for steepening is probably the way to go. “Be careful!”
I’ll end with one more MLK quote, especially appropriate for these times:
“Never succumb to the temptation of bitterness.”
