Dire Straits
October 31, 2021
Weekly Comment – October 31, 2021
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I think Mark Knopfler was ahead of his time with this one from 1982:
Yeah, now the work force is disgusted, downs tools, walks
Innocence is injured, experience just talks
Everyone seeks damages, everyone agrees that
These are classic symptoms of a monetary squeeze
On ITV and BBC they talk about the curse
Philosophy is useless, theology is worse
History boils over, there’s an economics freeze
Sociologists invent words that mean “industrial disease”
Even the band name is right: Dire Straits. Except now the song might be called Central Bank disease.
Certainly this week’s action had many market participants in dire straits, and there is no question we’re in the midst of a monetary squeeze. Short end rates have exploded higher, belatedly recognizing inflation pressure which is now being acknowledged by central banks. BOE’s Andrew Bailey recently warned the Bank “will have to act” to rein in inflation expectations, which he will have the chance to do at Thursday’s meeting. Last week the Reserve Bank of Australia abandoned Yield Curve Control by failing to defend the 10 bp target. RBA meeting is Nov 2, where it is expected to formally dismiss YCC. The FOMC announcement and press conference is Wednesday.
To give a sense of what many analysts refer to as “carnage” here are changes in two-year sovereign yields from the start of October to Friday: Australia (the undisputed winner) from 5 bps to 77, up 72. Canada, from 50 bps to 109. UK from 40 bps to 70. US from 26.5 bps to 50. Germany from -70.7 to -59.
Curves experienced hard flattening. In 2/10 yield spreads, from October highs to Friday (in bps): Australia 170 to 138. Canada 100 to 62. UK 64 to 34. US 129 to 105. Germany 57 to 47.
For the last two weeks I have started comments by noting changes in Eurodollar calendar spreads, which have aggressively trended in the direction of pushing rate hikes forward. These trends have continued. EDZ’21/EDZ’22 spread rose 4 to a new high this week of 66.5. On Oct 1 it was 29.5 for a one-month gain of 37. EDZ’22/EDZ’23 plunged 8 on the week to 61.0. It started the month at 62, but the mid-month high was 72.5. EDZ’23/EDZ’24 sank 10.5 from 27.5 to 17.0. On October 1 it was 43.5; Friday’s low was easily a new low for the year. Below is a chart of the condor, EDZ’21/Z’22/Z’23/Z’24. In October it exploded from -14.0 to 49.5. This is a monster move. It represents EDZ’21/Z’22 calendar minus EDZ’23/Z’24. It’s amazing this price action could occur without an actual hike, although it’s not as if it’s unprecedented; as the market sniffed out hikes in 2004, the EDM’04/M’05/M’06/M’07 went from 23.5 at the end of March 2004, to 130 in early May. But of course, that’s when the Fed went on to hike at every single meeting for two years. On the Short Sterling curve, the Z’21 thru Z’24 condor has trended from a low of 27 in Sept to 110 on Friday. L Z1/Z2 settled +93.5 and L Z3/Z4 at minus 17 (inverted).
What can we conclude from price action? The market is pushing central banks to hike. However, flattening and inversion (sterling) on the deferred spreads indicates that the global economy won’t be able to handle hikes and growth will suffer. Bill Ackman is vocally calling for taper in the face of high inflation. Goldman has moved their timetable for the first hike up to July 2022. The Fed is expected to announce tapering at Wednesday’s FOMC, which coincides with the Treasury refunding announcement. Actually, Treasury will release financing estimates for the quarter on Monday at 3:00 EST. Auction sizes are expected to be trimmed, specifically in 7’s and 20’s. A Reuters article cites NatWest, which estimates an $800 billion cut in nominal auction sizes in the 2022 fiscal year as compared with 2021. “The majority of those cuts will come in securities with a 7-yr duration or less, with a $2b per month cut in 2,3, and 5 years, and $3b per month in 7, 10, and 20-yr treasuries…” Should make the taper fairly painless, which ironically drives focus to actual rate hikes.
Interesting side note, last week’s Employment Cost Index was deemed “alarmingly big” at 1.5% in Q3 by Ian Shepherdson. (BBG) “If it doesn’t start to abate with larger workforce participation… ‘If that doesn’t happen, and wage growth continues to run at this pace, then Game Over for the transitory inflation argument’, he [Shepherdson] said in a note.
On another side note: China’s PMI was released at 49.2 from 49.6 last, representing contraction. Not too much of a surprise given continuing pressure on China’s huge property sector, thanks to Evergrande.
Coming up
Monday: ISM Mfg and Treasury Announcement
Tuesday: RBA
Wednesday: ADP, ISM Services, FOMC, Auction Refunding Ann
Thursday: BOE
Friday: US Employment Report
(Not an all-inclusive list, but it’s a big week)
OTHER MARKET THOUGHTS / TRADES
I was as wrong as I could be with respect to the idea of selling butterflies last week (see above), but apparently I was in good company as flies continued to stretch higher. EDU’22/EDH’23/EDU’23 which I thought was a decent sale at 2 settled 6.5. On the other hand, I also looked at buying 4EM 9850/9875cs for 5.0, theo settle 7.5 as gold ED contracts levitated.
Implied vol in the short end exploded. 0EZ 9912.5 straddle was 23.5 settle on Friday 10/22 ref EDZ2 9919.0, and settled 26.5 ref 9913.0 on Friday. 0EZ2 9912.5p were 1 bp on October 14 and settled 13.0 on Friday. Take THAT crypto!
Obviously, with rumors swirling about large hedge funds being blown up in the past week, the bid for vol has become a bit panicked. EDJ2 9912.5p settled 5.0 ref EDM’22 9956.0. Tempted to sell prices like these. April serials expire April 14 on EDM’22 underlying.
What is surprising is that VIX remains very low, ending Friday at 16.26, though forward contracts have some juice, for example Dec VIX (UXZ1 index) settled above 21. Also, treasury vol remains subdued relative to Eurodollar price action. FV one month vol is at 3.5 which is at the high end of the year’s range (3.75 in March), but the cash 5-yr yield at 1.19% is 25 bps higher than it was at the March peak. Have to look at being a buyer of TY vol in front of this week’s calendar.
| 10/22/2021 | 10/29/2021 | chg | ||
| UST 2Y | 50.0 | 48.9 | -1.1 | |
| UST 5Y | 122.7 | 118.5 | -4.2 | |
| UST 10Y | 165.5 | 155.2 | -10.3 | |
| UST 30Y | 209.0 | 193.5 | -15.5 | |
| GERM 2Y | -63.7 | -58.4 | 5.3 | |
| GERM 10Y | -10.5 | -10.6 | -0.1 | |
| JPN 30Y | 70.6 | 66.5 | -4.1 | |
| CHINA 10Y | 299.6 | 297.0 | -2.6 | |
| EURO$ Z1/Z2 | 62.0 | 66.5 | 4.5 | |
| EURO$ Z2/Z3 | 69.0 | 61.0 | -8.0 | |
| EURO$ Z3/Z4 | 27.5 | 17.0 | -10.5 | |
| EUR | 116.47 | 115.63 | -0.84 | |
| CRUDE (active) | 83.76 | 83.57 | -0.19 | |
| SPX | 4544.90 | 4605.38 | 60.48 | 1.3% |
| VIX | 15.43 | 16.26 | 0.83 | |
