Villains and Heroes
June 6, 2021 -Weekly Comment
“I guess when one’s young, it seems very easy to distinguish between right and wrong. But as one gets older, it becomes more difficult. The villains and the heroes get all mixed up.” Rene Mathis – Quantum of Solace (James Bond)
The bond market is bulletproof. It has absorbed all types of bearish news: high inflation data, increasing government deficits, labor shortages. The ten year yield hasn’t deviated far from 1.60% since March, ending Friday at 1.56%. down 2.6 bps on the week. This, despite the highest ISM Service number ever at 64.0, ADP payroll growth of 978k followed by a “disappointing” NFP of 559k with an unemployment rate of 5.8%. Suzanne Clark, President and CEO of the US Chamber of Commerce said, “The worker shortage is a national economic emergency, and it poses an imminent threat to our fragile recovery and America’s great resurgence.”
The argument that inflation is unsustainable is winning the day, with analysts like David Rosenberg and Lacy Hunt citing high debt levels, etc. Of course, the most powerful voice in favor of continued monetary accommodation in the face of transitory price pressures and slack in the labor market is that of the guy pulling the levers, Chairman Powell.
For the sake of historical curiosity, see the chart below from the mid-1970’s, prior to birth of most of our trading community. Unemployment was over 11% as inflation began to accelerate, from about 5% in late 1976 to a high of 14.7% in March of 1980. Unemployment bottomed at 5.7 in June of 1979. Two takeaways from this chart. First, inflation WAS “transitory”, it only accelerated for three years. Second, inflation was able to increase, even with the unemployment rate well above Friday’s reading of 5.8%. Of course, you wouldn’t have wanted to maintain long positions in fixed income during this particular transitory period, as the ten year yield went from 7% at the start of 1976 to over 13% in 1980.
Again. I remind you that the current ten year yield is 1.56%, with a real yield as defined by the ten-year tip of negative 90 bps, and even more negative than that if you use the last CPI data of 4.2%.
David Rosenberg, in making his argument for price increases merely being a one-time shift, often repeats that there is no “regime change”. The election of Obama, which some thought might produce inflation, didn’t. Bernanke’s unorthodox (at the time) QE policies didn’t spark inflation, nor did Trump’s tax cut package.
My personal feeling is that “regime change” indeed occurred, specifically with the change in the Fed’s framework in August of last year. That’s when curves started to steepen. Commodity prices had already bottomed prior to August, but never looked back since September. I’ll note one more thing about regime change which concerns data that will be released this week on the tenth, the Fed’s Z.1 flow of funds report. In 2007, on the cusp of the GFC, total Household debt was $10.577 trillion. Total Business debt was $10.678T and the Federal Gov’t came in at $7.376T. Roughly a third each, with the Federal Gov’t lagging. The last report is from Q4 2020. Household debt nearly unchanged at $10.935T. Total Business debt $17.719T (which the Fed sometimes refers to as being on the high side of historical norms as compared to GDP). And then there’s the Federal Gov’t at $23.621T, about three times higher than 2007. In my opinion, these shifts represent regime change, though not in the sense of being abrupt. If the footprint of the Federal Gov’t were about to become significantly smaller, it would likely have disinflationary consequences. In fact, that’s part of Rosenberg’s thesis, that Biden’s hand will be constrained by a new Congress following the 2022 elections. Maybe so, but sometimes markets operate with lags. One other note, the Fed’s Household Debt and Financial Obligations ratio is last at 14.71%. That is one of the lowest ratios ever, and why Fed officials often say that the Household balance sheet is in good shape, in aggregate.
The next quarterly Z.1 report is released on Thursday. Of more immediate concern to the bond market is CPI, also released on Thursday, expected 4.7% yoy from 4.2% last, with Core expected 3.4%. Again, this is with the ten year yield at just 1.56%. Additionally, the market will need to fund approximately $99 billion above maturing amounts with this week’s auctions of $58b 3-yrs, $38b 10-yrs and $24b 30-yrs.
Tin foil for this last bit. When they say the only choice is to inflate out of debt, it becomes clear that what they’re talking about is a government bailout of government. Oh sure, the government shifted some private debts from business and households to its balance sheet after the GFC. The response due to COVID has been extraordinary. Now the government needs to save itself with inflation. Sure, there’s a concern that if inflation jumps rates will rise, and the interest burden will become onerous. But not if rates can be held artificially down and higher price levels help expand nominal GDP in order to lessen the debt-to-GDP ratio. Perhaps I am being cynical here, mixing up villains and heroes, but if you thought the government’s response to help the public get through covid was heroic, just wait until you see the lengths to which the government will go to help itself.
OTHER MARKET THOUGHTS/TRADES
The popular trade of the week was buying put spreads and selling call spreads. Of note, 2EZ 9900/9787ps was bought vs selling 2EZ 9925/9937ps. 2EZ options have EDZ’23 as the underlying future and expire on 10-Dec-2021. Open interest in the 9900p rose about 160k on the week; the package traded around 100k. Settlements on Friday: 9900/9787.5ps 4.25 and 9925/9937.5cs 4.25, so flat with EDZ3 9906.5. That is, a put spread just 6.5 out of the money settled at the same price as a call spread 18.5 out of the money. This is available due to skew. For example, the 9937.5c settled 4.5, 31 out of the money, while the 9875p settled 8.0, 31.5 out of the money. One might conclude that the demand for puts represents insurance purchases for the case of higher rates, and that since the risk has been adequately addressed and priced, it’s not quite as likely. That’s what the Fed is telling you. Weakness in USD might be telling you something else.
Related to buying of put spreads in greens rather than further out points up another somewhat interesting aspect of the week’s trade: The steepest part of the curve has been greens to blues, or contracts in the year 2023 vs contracts in 2024. The peak one year spread has been EDM23/EDM24 which closed the week at 66.5. These elevated one-year spreads are partially due to the June 2023 end of libor and partially due to the idea of Fed hikes commencing two or so years hence. Consider the September expiration contracts: EDU’21 settled 9988.0, up 0.5 on the week. EDU’22 at 9974.0, up 1.0 on the week, EDU’23, 9921.0 up 1.5 on the week, EDU’24 9862.5 up 4.5 on the week. The one-year spreads are as follow, EDU’21/22 14.0, down 0.5, EDU’22/23 53.0, down 0.5 and EDU’23/24 58.5, down 3.0. All yields declined slightly on the week, but the year 2022/2023 spreads held up better than the year behind. Small moves, but it could be that the market is thinking removal of Fed accommodation could be slightly sooner than previously expected.
Nearing the July 1 date of the 100th year anniversary of the China Communist Party. The yuan eased slightly this week with the increase in FX required reserve ratio, the ten year yield rose just over 4 bps to 3.13%. Things in China will likely be as tightly scripted as a Biden news conference, but there are probably some actors who wish to cause disruption on such a momentous occasion.
| 5/28/2021 | 6/4/2021 | chg | ||
| UST 2Y | 14.1 | 14.9 | 0.8 | |
| UST 5Y | 79.5 | 78.4 | -1.1 | |
| UST 10Y | 158.6 | 155.9 | -2.7 | w/I 156.2 |
| UST 30Y | 226.2 | 223.8 | -2.4 | w/I 224.2 |
| GERM 2Y | -66.2 | -67.1 | -0.9 | |
| GERM 10Y | -18.3 | -21.3 | -3.0 | |
| JPN 30Y | 66.8 | 69.0 | 2.2 | |
| CHINA 10Y | 308.7 | 313.0 | 4.3 | |
| EURO$ U1/U2 | 14.5 | 14.0 | -0.5 | |
| EURO$ U2/U3 | 53.5 | 53.0 | -0.5 | |
| EURO$ U3/U4 | 61.5 | 58.5 | -3.0 | |
| EUR | 121.92 | 121.68 | -0.24 | |
| CRUDE (active) | 66.32 | 69.62 | 3.30 | |
| SPX | 4204.11 | 4229.89 | 25.78 | 0.6% |
| VIX | 16.76 | 16.42 | -0.34 | |
https://www.federalreserve.gov/releases/z1/20210311/html/d3.htm
https://home.treasury.gov/system/files/221/TBACRecommendedFinancingTableQ22021-05052021.pdf
