Can’t depend on YCC
April 4, 2021 -Weekly Comment
Net changes on the week in eurodollars: Whites -2.125, Reds -10.625, Greens -19.375, Blues -20.75 and Golds -15.75. The five year was the leader on the treasury curve, up 12 bps to 97.4 (a new high), with tens up 6.2 and thirties essentially unchanged. 5/30 treasury spread is 139, the lowest level since late January, at significant support of 137 to 139.
Reds are the second year out, greens and blues are the third and fourth years. Obviously the surge in yields in years 3 and 4 relative to the front end of the curve is telling us that the Fed will certainly be tapering/tightening in two years. Even a three-month spread like EDM2/EDU2 settled at 9.5 on Friday, a new high, having been between 1.0 and 2.5 from last September through January. That spread reflects a hike probability of over 35% during that three month period, which is only 1 ¼ years away. EDU1/EDU2 settled at a new high of 22.0 which signals near certainty of one hike over that year.
Last week Mfg ISM surged to 64.7, the highest level since 1983. Unemployment fell to 6.0% with non-farm payrolls jumping by 916k. This week ISM Services is released on Monday, expected 59.0. The high in 2018, the year in which almost all economic data made new highs in the Trump era, was 60.9. On Friday PPI is released, with Core yoy expected 2.7% vs 2.5% last month. The high in 2018 was 2.9%. Powell has repeatedly vowed to keep rates low because of continued economic slack, especially in the service sector, and because inflation cannot be sustained due to generational headwinds. We get info on both fronts this week.
It’s worth noting that in 2007, just following the height of economic activity before the GFC, the unemployment rate bottomed at 4.5%. In 2004 as the Fed began to hike it averaged around 5.5%. In 2006 it averaged 4.6%. To think that the Fed must wait for something like 4% unemployment before raising the FF target from the emergency level of 0.0 – 0.25% is utter folly. In only three out of the past twenty years has unemployment been at 4% or lower.
In terms of the sustainability of actual price increases (that the Fed promises to look through) I tend to think about the example of Jon Corzine blowing up MF Global by loading up on peripheral debt. There are those who say, “Ultimately he was right, sovereign debt of Portugal and Italy, et al. had a tremendous rally.” No. He was wrong. He destroyed the company, dipping into customer funds in the process. He probably should have gone to jail. Don’t be Jon Corzine.
Sure, it might be the case that there is a one-time upward adjustment in prices followed by stability. However, the market is not currently giving any indication of that. TIP breakevens are at new highs with the ten year above 237 bps, a level not seen since 2013. Back month euro$ contracts easily set new lows on Friday. There will come a time when the market signals that the rise in yields has run its course. In my opinion, we’re not there. Too many trapped longs hoping the Fed will come to the rescue with YCC. In that regard, look at ten-yr JGBs. For the last two quarters of 2020 the yield ranged between 0 and 5. In February it rallied to 15.5, then came back down to 6.8 in late March. Now it’s back to 12.
FOMC minutes are released on Wednesday. On Thursday Powell participates in an IMF Forum on the Global Economy, starts at 12:00. There will be more assurances that inflation is temporary, that growth is Covid dependent, that there is a lot of slack in the labor market. Powell will tell us that the current emergency policy is appropriate. By the way, the NY Fed’s Q2 Nowcast is 6.2%.
With regard to the front end of the market, I remember a time when banking issues caused front Eurodollars to sell off due to credit concerns. However, April and June Eurodollar contracts settled at 9981.5 and 9982 respectively, both lower in yield than the current libor setting of 19.975 (Thursday). I don’t know enough about banking activities (and apparently neither do a lot of the banks themselves) but there were a couple of downgrades relating to the Archegos episode. I don’t want to single out any one bank in particular, BUT, Credit Suisse, right on its own website has a tidy summary:
https://www.credit-suisse.com/about-us/en/investor-relations/debt-investors/ratings-credit-reports.html
Moody’s, S&P and Fitch are all have negative credit outlooks, with Moody’s giving this summary:
The negative outlooks on the senior unsecured debt, long-term issuer and deposit ratings – where applicable – of CS and CSG reflect Moody’s view on (1) emerging signs of a higher-than-anticipated risk appetite or potential deficiencies in its risk management, audit, compliance or governance control processes and frameworks, as highlighted by a likely material loss from unwinding concentrated leveraged equity and derivatives’ exposures following the failure of a US hedge fund client, in addition to the aggregate risk the group assumed in relation to Greensill’s founder and his companies culminating in the wind-down of CS’s supply chain finance funds…
We all have unquestioning faith in our Central Banks to backstop all of the messy problems in the world of finance, oh, and climate change… and of course equality, but I have to wonder how anyone can sell EDM1 9981.25 puts at 1.25 or 1.5 bps. It’s not that they will definitely finish in the money, although at Thursday’s libor setting they would be darn close to breakeven. It’s that there is supposedly a credit aspect in the contract, and recent escapades highlight the fact that not all lending is ‘money good’. EDZ1 is a bit more reflective of these concerns for year-end, having settled at 9972.0 Friday, down 2.5 on the week. I had been surprised that the 9975 straddle was recently sold down to 8.0; it settled 9 on Friday. I had suggested looking at EDZ1 9975/9962p spread for 2.5, still a reasonable buy for 3.0 having settled 3.25.
| 3/26/2021 | 4/2/2021 | chg | ||
| UST 2Y | 13.9 | 18.4 | 4.5 | |
| UST 5Y | 85.4 | 97.4 | 12.0 | |
| UST 10Y | 165.8 | 172.0 | 6.2 | |
| UST 30Y | 236.6 | 236.3 | -0.3 | |
| GERM 2Y | -71.5 | -70.8 | 0.7 | |
| GERM 10Y | -34.6 | -32.8 | 1.8 | |
| JPN 30Y | 66.2 | 69.3 | 3.1 | |
| CHINA 10Y | 319.8 | 319.9 | 0.1 | |
| EURO$ M1/M2 | 8.5 | 14.5 | 6.0 | |
| EURO$ M2/M3 | 42.5 | 52.5 | 10.0 | |
| EURO$ M3/M4 | 72.5 | 77.0 | 4.5 | |
| EUR | 117.96 | 117.60 | -0.36 | |
| CRUDE (active) | 60.97 | 61.48 | 0.51 | |
| SPX | 3974.54 | 4019.87 | 45.33 | 1.1% |
| VIX | 18.86 | 17.33 | -1.53 | |
