July 15. Late Cycle Behavior… What’s next?
Both Jeffrey Gundlach and Bill Gross made bullish calls on commodities earlier in the year. I think I recall Gundlach saying a rise in commodities is ‘classic late stage behavior’. I did a quick search and found this quote from mid-January: “Commodities always rally sharply – much more sharply than they have so far – late in the business cycle as we lead into a recession.”
This week was a trying one for commodity bulls. In no way am I trying to cast a negative light on the earlier calls, because they were absolutely correct. The question is, if a commodity rally is ‘classic late stage’ stuff, and if commodities have now turned, what comes next?
On Wednesday, front month WTI took a dive, falling $3.73. On the week it fell 2.79 to 71.01, yet it is still well above the lows from early June (64.00 to 65.00/bbl). However, other commodities have absolutely plunged. Silver fell to a new low settle Friday. Soybeans made new lows, same with corn. As mentioned during the week, base metals have melted, with Dr Copper down 17% from its high in June. These moves are related to trade war concerns and strength in the USD. There are also a slew of technical factors, the intricacies of which I don’t pretend to know. Not only don’t I know, it seems as if some of the most sophisticated players have been caught out, as a Reuters article on energy notes: “Trading desks of oil major BP, and merchants Vitol, Gunvor and Trafigura have recorded losses in the tens of millions of dollars each as a result of the “whipsaw” move when the spread [between WTI and Brent] reached more than $11.50 a barrel in June, insiders familiar with their performance told Reuters.” I don’t think the article (link at bottom) does justice to a complex topic, but it gives a sense of underlying turmoil. I’ve highlighted vicious rallies in near WTI calendar spreads in daily notes, and I’m sure there are other more nuanced moves between products. Actually, spread moves have had all the nuance of a sledgehammer. The point is that smooth, discrete moves are perhaps becoming less of a feature, (and more of a bug?)
These moves come at the same time that many (IMF, BIS, etc) are sounding the alarm on excessive global debt. Financial bloggers anxiously scream that these debts will NEVER BE REPAID! That’s not really the crux of the problem. The issue is whether the debts can be serviced and rolled. The problem is that one man’s debt is another man’s asset, and if the ‘collateral’ underlying these debts were commodities, why, then we might have reason for concern on both counts. Especially if those debts are dollar denominated. Thankfully though, tech stocks are the pillars of the US economy, and it’s there that we can take solace in *socially driven and beneficial for mankind* decision making, an example of which is WeWork banning meats from company events and expense reports. It’s really no wonder that Nasdaq soared to a new high this week. However, on Tuesday the Russell 2000 posted an outside day and closed lower, essentially leaving a double top just under 1710 (cash index) on June 21. These highs remain intact (even with a new high in Nasdaq), and represent strong resistance. It’s hard to buy into the scenario of robust economic growth if only a few tech names provide all the juice.
The interest rate curve is reflecting similar trepidation with respect to forward economic prospects. On Friday, the 30-yr and ultra bond contracts had new high settlements, exceeding highs set in late May when concerns about Italy gripped the market. Inversion on the Eurodollar curve keeps edging closer in time. Many one-year Eurodollar calendar spreads made new recent lows, for example, EDM19/M20 settled at a new low of just 8.5. This spread is one year forward, and more or less indicates that the Fed’s tightening campaign will be over by then. If there’s any doubt as to timing, the next spread, EDU19/U20 is only 2 bps, and then… depression set in. https://www.youtube.com/watch?v=GbVaisNPgh4
I mean, then inversion sets in, with EDZ19/EDZ20 at MINUS 2. Last week was the first time this spread traded negative, and it’s the nearest one-yr inversion. The red Eurodollar pack (2nd year forward) is at a higher yield than the green pack (3rd year) which in turn, is at a higher yield than the blue pack (4th year) 2.955%, 2.9337%, 2.9175%. These spreads are at new lows for this cycle, and near lows of previous tightening cycles. Until the Fed changes its tune on future gradual rate hikes, the back end of the curve is announcing that, gradually, rate hikes will choke the economy.
Doesn’t this inversion signal possible risks to financial stability? Perhaps. However, the semi-annual monetary report released by the Fed on Friday doesn’t really address that topic in the section entitled, Developments Related to Financial Stability. Instead, the Fed says that risks are generally low, while noting that “valuation pressures in various asset markets remain elevated by historical standards…” and that “commercial property valuations continue to be stretched.” The report says “Risks from abroad are moderate overall” and concludes this section with “Globally, potential downside risks to internat’l financial markets and financial stability include political uncertainty, an intensification of trade tensions, and challenges posed by rising interest rates.” On the last point, the Eurodollar curve is sending up a flare. On trade tensions, commodities might be sending up a flare. And on political uncertainty, well, we can all draw our own conclusions. This week’s Trump/Putin summit will perhaps paper over uncertainties regarding US/Russia relations. On the other hand, the prospect of China using slow currency depreciation vs USD is another clear risk to international capital flows.
So we have a pretty good handle on possible threats, and some pockets of the interest rate markets are gently pricing these risks. The commodity complex has been more strident. VIX is on a summer stroll through the countryside. Implied volatility in interest rates is similarly languishing near lows. It’s hard to lay out premium when every shock is absorbed in shorter and shorter cycles. This is when tails should fatten.
| 7/6/2018 | 7/6/2018 | chg | |
| UST 2Y | 254.1 | 258.2 | 4.1 |
| UST 5Y | 272.1 | 272.7 | 0.6 |
| UST 10Y | 282.9 | 282.9 | 0.0 |
| UST 30Y | 293.8 | 293.3 | -0.5 |
| GERM 2Y | -65.8 | -66.3 | -0.5 |
| GERM 10Y | 29.2 | 28.0 | -1.2 |
| JPN 30Y | 67.9 | 67.9 | 0.0 |
| EURO$ Z8/Z9 | 32.0 | 31.0 | -1.0 |
| EURO$ Z9/Z0 | 1.0 | -2.0 | -3.0 |
| EUR | 117.44 | 116.85 | -0.59 |
| CRUDE (1st cont) | 73.80 | 71.01 | -2.79 |
| SPX | 2759.82 | 2801.31 | 41.49 |
| VIX | 13.37 | 12.18 | -1.19 |
