Inconceivable and Irrational
June 10, 2020
–Yields fell and the curve continued to pull back from Friday’s new highs. For example, 2/10 which ended Friday just above 69 bps was 62.5 at futures settlement. The one-year euro$ calendar EDM21/EDM22 settled back at 7.0, having been 12 on Friday (there is a large core long of >100k contracts in that spread from ~6.5). The ten year yield fell 5.3 bps to 83 bps.
— Implied vol exploded on bonds. USN 174^ vs 174-02 was 3’04/3’07 before the open. End of day USU settled 174-10, and USN 174^ 3’28s while 174.5^ 3’24s. Up about 20 ticks from morning in front of today’s FOMC. I calculate 174.5^ premium equivalent to a bit over 16 bps with just two and a half weeks to go. Let’s compare that with July midcurve straddles which expire in 30 days (2 weeks later). 0EN 9975^ settled 5.5 bps vs EDU21 9974.5. 2EN 9962.5^ settled 10.5 vs EDU22 9964.5 and 3EN 9950^ settled 14.0 vs EDU23 9946.0. What does this mean? To me, it means the market has bought into the Fed’s yield curve control rhetoric whether it’s overtly implemented or not. Straddle levels indicate that contracts out to three years are barely expected to move, while the long end, as exemplified by the bond, has plenty more room for play. 5.5 for a one-month straddle on the second red? Inconceivable.
–The tacit acceptance of YCC is one structural aspect of the market: the front end is thought to be more or less cemented in place, likely comforting to the Fed. What is increasingly uncomfortable is the speculative froth in equities, which of course, reminds me of the late 1990’s dot.com frenzy. I had noticed then, that on national holidays, when stocks were open but many businesses were closed, that equities inevitably rallied, as people with a day off would sit home and buy shares. Now, as many commentators have pointed out, we have an entire population sitting at home looking for “cheap” stock plays. As a paper from HSBC pointed out, there are no sports to wager on, might as well open a Robinhood account for some action. The volatility in some of these stocks is enormous. It’s here that I should re-tell my early 2000 story about ECNC, but I don’t have the time…will re-post later. In any case, this new speculation, even though it’s driven by “main street” retail investors, creates the appearance that the Fed has once again helped “Wall Street” at the expense of main street. A bloomberg piece notes unharnessed buying activity in shares of bankrupt companies, even as their bond prices telegraph that the equity portion of the capital structure will be wiped out. We’ll see today how (and if) the Fed responds to this. Recall that Greenspan’s famous “irrational exuberance” speech initially sparked selling, but that didn’t last for long.
From Greenspan’s speech, Dec 5, 1996
But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.
