It’s Never the Trade, It’s Always the Size
The title is one of the favorite sayings of a friend of mine (WHM). Obviously, a bad trade of small size can be absorbed. But a large trade coupled with a sudden evaporation of liquidity can be a disaster. Especially when there’s leverage involved.
On Thursday, the TY straddle expiring on unemployment day traded a new low 21/64’s. On what used to be the biggest data release of the month, the breakeven in the underlying TYU7 contract was only 10.5/32’s either way from the strike price of 126-08. Ultimately, the sellers were proven correct, with net change on the day of -9/32’s to 126-02.5.
We’re in a period of steady growth, low unemployment, moderate inflation, low rates. Risk has been squeezed out of all markets. Implied vol has followed realized vol lower. The curve implies lack of Fed action, and little expectation of increased inflation. Corporate spreads are tight. The US savings rate is dropping. Asset prices have pressed higher to capture ‘yield’ and are overvalued by many metrics. https://www.advisorperspectives.com/dshort/updates/2017/08/03/market-remains-overvalued
The market has rewarded and continues to reward those that sell volatility. The chart below is a good representation of the year; it’s the 5yr treasury yield. The recession indicator of an inverted curve is unlikely as the market prices out future tightening –in spite of Friday’s strong employment report with a rate of only 4.3%. The spread of January 2018 to January 2019 Fed Funds settled 24.5 Friday and has been bouncing around ¼%, suggesting just one hike next year.
When markets price out potential risk, they also price out cushion for loss. The natural tendency is to increase the size of the trade in order to make the same income. That’s when position unwinds can overwhelm fundamentals and cause dramatic overshoots. There are probably more potential catalysts than ever that could upset the current ‘equilibrium’, but as a client said to me Friday, “the first disturbance will be sold.” It’s really the secondary effect that we have to be concerned about. Even in the political realm, there is clamp-down on volatility with the new Chief of Staff, General Kelly.
An interesting question posed last week by a client was this: If there were a nuclear incident involving North Korea, what would be the best trade? I responded with a variety of ideas; I won’t go into specifics, but some were pretty obvious. Buy VIX, buy gold calls, buy treasury calls, buy swiss. It’s simply an exercise to consider what COULD happen, and the catalysts aren’t black swans, they’re fairly well known. It’s just that the odds are low. In addition, timing is everything. For example, Greenspan is calling our current rate environment abnormally low; a ‘bubble’, and further added that when rates DO rise, they may do so rather rapidly. Of course, his famous ‘irrational exuberance’ speech in 1996 preceded the equity market top by years.
My bias is to side with Greenspan. As the TBAC warned last week, the Fed’s balance sheet adjustment has the potential to be messy. “More importantly, the TBAC also warns that with IG corporate net leverage near all time highs, the result of ‘expectations of permanently lower rates and tight spreads’, they are “more sensitive to higher rates.” In other words, a sharp, or even gradual, rise in yields will impact corporate debt disproportionately.” (ZH) In addition, the treasury’s borrowing schedule has increased, with $500 billion expected to be auctioned in Q4. Given that some of the tax package was supposed to be financed with savings from health care reform, the prospects of the former have been severely curtailed by the failure of the latter.
While many analysts point to an inverted curve as the best predictor of recession, perhaps this time it might come as a result of longer rates moving higher. It might not be the result of household balance sheets coming under stress; it may be more likely to arise from pressure on corporate balance sheets. From Q1 2014 to Q1 2017, debt outstanding of households has risen only a total of about 9% (to $14.88T) while total business debt has increased 20% (to $13.74T).
There are just a couple of other quick observations I would make, without necessarily drawing any conclusions. First, there are some small signs of dislocations in the corporate world. For example, IBM (the company Druckenmiller once described as the posterboy for excessive financial engineering) has fallen around 19% from this year’s high, lopping >$20 billion of market cap, which is now down to $135B. GE has fallen by a similar percentage, and has seen > $50B evaporate from the high.
BBG had a story noting a recent disconnect between large and small cap stocks. The chart below gives an indication. It may not be of particular concern at the moment, but bears watching. It shows the DJIA in blue, and the Russell in white. In the last couple of weeks, the Dow has soared while Russell has turned down.
Finally, I would like to add a chart noting the explosive growth in open interest of the Ultra Bond contract, symbol WNA on Bloomberg. There were several large block buys of WNU7 this past week, beginning Wednesday at a low price of 165-22. The DV01 on the contract is $292, so every one point move is ~ 3.4 bps. Why the demand for an especially long duration contract? Contract price in white, open interest in green. Since last year open interest has risen by 45%.
