All the good news is out
September 20, 2020 -Weekly comment
Last week featured the FOMC meeting. Here’s the summary: funding rates will be held near zero for the next several years in support of our new inflation-averaging scheme. We will continue our QE buying at around the same pace as currently. The economy needs more fiscal support.
Let’s take the first part. Rates stay near zero. The market had already substantially priced that outcome. On the week the two year note rose 1 bp to 13.7 and fives rose 2.7 to 27.7. The green euro$ pack, (the third year out, EDZ’22 thru ED’23) settled on Friday at 99.70875 or just above 19 bps. The previous Friday it was 99.73375, so the change in yield was an increase of 2.5 bps. It’s true that the MOVE index made a new all-time low, so in terms of perceived forward volatility, the market did give a nod towards the Fed’s new inflation-averaging framework. But yields had already priced the outcome of “low for long” and actually increased slightly. No additional help.
Now for the second part. QE at the same pace (~ $120b per month). This could almost be thought of as a modest tightening of conditions. The amount of bond supply is growing, both from government and corporates. Through August $1.7 trillion of corporates have been issued. Spreads remain remarkably tight. This week the Treasury auctions $52b in two-year notes, $53b fives, and $50b sevens, and an additional $22b 2y FRNs. Same amount of Fed buying, more supply. No additional help.
The Fed wants more economic support from fiscal policy. A package should be forthcoming, but is currently the victim of political wrangling, which is only going to get more contentious with the fight to replace Justice Ginsburg. Fed and fiscal policies provide a good deal of the oxygen to stoke the flames of asset appreciation. The air supply is being cut back. The Fed’s balance sheet has gone sideways for the past three months.
Last week I considered equity options and highlighted large open int in Sept AAPL 112.5p of 115k. Closed at 106.84 so those puts were 5.66 in the money. On the week AAPL declined 4.6%. From the close on Sept 1 of 134.18 (almost immediately after it began trading on the split adjusted basis), it is down 20%. Is the price action from the largest market cap company in the world a signal to take a more cautionary stance in general?
Now let’s shift from macro to micro. Zoltan Poszar changed his opinion and now says turn-of-the-year funding pressures will be muted. The reason has to do with the Fed’s scoring of capital ratios for big banks, but for our purposes the market reaction tells the story. The December euro$ contract rose 2.5 bps on the week to 99.735. Spreads encompassing the turn declined. For example, EDZ0/EDZ1 one-yr calendar jumped 5 bps on the week, from -9 to -4. The spread between FFF’21 and EDZ’20 (a proxy for FRA/OIS) settled at a new low on the year of 19.5 bps. In March this spread had surged to 38. There was a reaction in terms of direction, but the magnitude was modest at best.
In the grand scheme of things, this week’s moves in rates across the curve don’t have much bearing. The broader theme is that rate markets are not providing any additional fuel to support long dated assets. If investors are inclined to buy duration (including stocks), they really have to depend on Powell’s promise of low funding rates. However, if you trust the Fed on that score, don’t you have to put equal faith in the idea of the Fed generating inflation over 2%? And might that not negatively impact the value of long dated assets (including long bonds and equities)? All of the supportive factors have reached temporary limits. Short rates are not going negative. QE buying is not likely to accelerate for a while. Fiscal stimulus is deadlocked. Spreads are tight. Even with respect to year-end funding, the good news is out.
On Thursday. Powell and Mnuchin will testify before the Senate banking Committee to beg for more support from the fiscal powers. The next FOMC is Nov 5, just under seven weeks away and just after the election. It’s highly unlikely that the Fed will change its stance on bond purchases before that time as it could be construed as political meddling. Longer duration assets are likely to be weighed down over the next several weeks, not so much because of the election outcome, but because there will be no overt additional financial help.
OTHER MARKET/ TRADE THOUGHTS
Capitulation on display this week with the crumbling of implied volatility. We bow to the premise of total control of the short end by the Fed overlords. The MOVE index has made an all time low.
Even if one isn’t an option trader, here’s a price that should seem intuitively cheap to even those that aren’t involved in markets at all: Eurodollar contracts price a forward three month libor rate into the future. Currently, three-month libor is around 23 bps with the Fed Fund rate around 9 bps. The September 2023 contract, three years forward, is at a price of 99.665 which is a yield of 33.5 bps. In other words, it is only 10 bps higher in yield than the current libor rate. The 9962.5 straddle for this contract is 50.5 bps, the lowest I have ever seen for a straddle that far out in time; there are 1093 days until expiration on Sept 18. 2023. When one considers all the crazy events that have taken place in 2020, pricing for almost no change in the next three years seems somewhat presumptuous. On Friday, the EDU’23 99.50 put, a 50 bp strike price, settled 18.5 bps. If the Fed were to hike by just two 25 bp increments, with a mid-point target in FF of 62 bps, these puts would be in the money by more than their initial premium as the ED future would likely trade around 9915 to 9920. Cheap insurance over three years if you have any exposure to higher rates.
Below is a five year chart of the Bloomberg Ag Index (Soybeans, Corn, Wheat, Sugar, Bean meal and oil, Coffee, Cotton). There’s been a lot of talk recently about commodities having their day in the sun, and this chart supports that idea.
| 9/11/2020 | 9/18/2020 | chg | ||
| UST 2Y | 12.7 | 13.7 | 1.0 | |
| UST 5Y | 25.0 | 27.7 | 2.7 | |
| UST 10Y | 66.6 | 69.2 | 2.6 | |
| UST 30Y | 141.7 | 145.1 | 3.4 | |
| GERM 2Y | -69.3 | -69.6 | -0.3 | |
| GERM 10Y | -48.1 | -48.5 | -0.4 | |
| JPN 30Y | 57.8 | 58.3 | 0.5 | |
| EURO$ Z0/Z1 | -9.0 | -4.0 | 5.0 | |
| EURO$ Z1/Z2 | 3.5 | 3.5 | 0.0 | |
| EURO$ Z2/Z3 | 13.0 | 12.5 | -0.5 | |
| EUR | 118.48 | 118.40 | -0.08 | |
| CRUDE (active) | 37.65 | 41.32 | 3.67 | |
| SPX | 3340.97 | 3319.47 | -21.50 | -0.6% |
| VIX | 26.87 | 25.83 | -1.04 | |
