High-Pressure Uncertainty
“If hell is expanding at a slower rate than the rate at which souls enter hell, then the temperature and pressure in hell will increase until all hell breaks loose.”
–Part of the answer to a chemistry midterm dealing with Boyle’s Law. If you don’t read anything more, at least click this amusing link. http://www.alphadictionary.com/fun/hell.html
I started with the above quote because, in scanning the global news and trying to determine what is important to markets, it seems as if the entire world is “breaking loose”, and that shifts can happen in a hurry with implications far beyond the markets. For example, the overt suggestion by Biden that the US is exploring covert cyber attacks against Russia (huh?). And the response, “The fact is, US unpredictability and aggression keep growing, and such threats against Moscow and our country’s leadership are unprecedented, because the threat is being announced at the level of the US Vice President,” Putin’s spokesman Dmitry Peskov said. Then, there are repeated attacks on US Navy ships from Yemen. And closer to home, Chicago shootings (38 over the weekend, 37 if we omit the guy that was just “grazed”). If the Cubs weren’t winning it would be easy to get the sense that something isn’t quite normal in this world. :- l
The uncertainty extends to the Central Banks, clearly articulated in Yellen’s speech on Friday: ‘Flying Blind, The Fed Considers the Economic Landscape.’ Well, that really wasn’t the title of the speech, but it might as well have been. Yellen referred to five areas where more research is needed. 1) Hysteresis –right there with topic number one it’s obvious that the speech is going to be mumbo-jumbo –what the heck is hysteresis? 2) Heterogeneity 3) Financial Linkages to the real economy (still studying this one, eh?) 4) Inflation Dynamics (the Fed’s not too sure how this works) and 5) International Linkages.
The lines that caught the market’s imagination are these:
If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects.
PLAUSIBLE? Is that how we’re doing things now? Mere conjecture? It’s plausible that the rise in financial assets from QE will spark sustained, increased consumer demand and therefore business investment in CAPEX and a self-fulfilling circle of increased productivity, beneficial hiring and increased wages and social harmony. But it didn’t really pan out that way, now did it? Plausible: ‘so crazy it just might work.’
Let’s get back to the reality of where prices actually are, as of Friday. Consider the two charts below, the top panel covers one year’s time frame and the second spans five years.
Consider the lower, longer term chart, in the context of recent price action more easily viewed on the one year chart. Are you a buyer, or a seller? If you consider the absolute level, it looks ‘cheap’. On a technical basis it appears to be turning. As of Friday; it has made a 3 month high. If viewed just through the prism of the 100 day moving avg (green line) one would HAVE to buy this chart. If, over the past 5 years you had only traded when the 100 dma was crossed, there would have been a couple of times you would have taken small losses, but you’d have completely captured the big moves. The chart in question is a measure of the curve, the red Eurodollar pack vs the golds (2nd year vs 5th year forward). This chart correlates well with 2/10 treasuries, inflation premiums, etc.
Are there fundamental reasons for a breakout? Yes, in spades. First, Yellen’s comments support the idea of a Fed willing to allow increased inflation and expectations. Working backwards, BoE’s Carney said on Friday he’d be willing to tolerate some inflation overshoot to accommodate economic strength. At Friday’s conference, Boston Fed’s Rosengren said. “Because of financial stability concerns, the balance sheet composition [of the Fed] could be adjusted to steepen the yield curve.” The Bank of Japan suggested an increased inflation target and is only pegging the curve out to ten years. The German bund closed with a positive yield for the past two weeks. Finally, yoy comps in energy are going to start to filter in to inflation data. If oil simply stays here, the yoy increase in WTI will be up 60% from January’16 to January’17. I won’t bother to re-produce the chart here, but 2/10 is quite correlated to the price of oil.
I would note there was a huge steepener block trade on Wednesday: +50242 TYZ 129-25 / -12790 WNZ 177-20. About $4.1 million per bp ($320/ bp on WNZ, $82 in TYZ6). As of Friday, both sides are in the black with TYZ 129-275 and WNZ 176-19.
All this isn’t to suggest that the curve still couldn’t flatten. It’s ‘plausible’ under several circumstances. For example, if the stock market implodes, perhaps the ftq bid occurs along the back end. Continued strength in the USD might have the same effect.
And, there are an awful lot of indications that the economy is stalling, which may lead one to believe that yields must continue to fall and the curve flatten. But I’ll end with two thoughts. First, an increase in inflation expectations and actual inflation needn’t be correlated to economic growth over the short term and second, as observed by many analysts and lived by many traders, the central banks have distorted markets. Their collective narrative may be changing. Once again, consider the red/gold chart above in mid-2013, when Bernanke first suggested a taper: red/gold doubled from 150 to 300 by the end of the year…
Speeches this week: Fed Vice-Chair Fischer on Monday and NY Fed’s Dudley on Thursday.
