It’s the supply chain, mate. It’s broken.
November 28. 2021 – weekly comment
Supply chain disruptions. All over the news. Widespread reports of chip shortages, images of ships stranded outside of ports, trucks idling at pick up points. The media is now constantly advising to order early, and be prepared to pay much higher prices.
The analogy I would make in financial markets is a lack of liquidity. Same thing: I THOUGHT I could buy all the supply I needed, but there is no one there to sell it at the price I need. Or the next price. Or the price above that.
This was on display on Friday. A crazy market, with pumped vol. Oil crash (CLF2 down 13%). Stock decline (SPX, NASDAQ and DJI down 2.2 to 2.5%). VIX jump, +10 to 28.6. Dollar pullback. Yield plunge with the ten-year shedding nearly 16 bps to 1.483%. Star performers on the euro$ curve were June, Sept and Dec 2023 contracts, up 21 on the day. However, EDZ3 settled at a price of 98.435 or 1.565%, consistent with a FF target of 1.25 to 1.50%. This rate is still significantly above the Fed’s projections as of September for year-end 2023, which showed a median of 1% (six members’ dots were 1.125%).
There have already been many articles bemoaning the lack of liquidity in the treasury market. For example, the FT ran a piece on Nov 9 (linked at bottom) in the wake of the Nov 8 Liquidity Report by the US Treasury, Fed, et al. The FT article noted position unwinds that occurred in early November; clearly the Bank of England and Bank of Canada roiled markets at that time, leading to well-publicized losses for several hedge funds. The result is wider and smaller markets, especially so now. Hedge funds have cut activity going into the end of the year. Again from the FT: “JPM research from Nov 5 showed that market depth [in treasuries], one measure of liquidity, had declined to the lowest levels since summer, when fears about the effect of the Delta variant on the US economy hampered liquidity.” And now we have Omicron.
So if I’m a treasury option market-maker being asked for a quote on a 20 delta call on a futures market that is showing 200 a side, I’m going to either quote small size or widen the market, knowing there is a strong possibility of missing the futures hedge. Obviously implieds should shoot higher, and they did, with treasury vol at the highest level since the late Q1 surge to higher yields. I marked TYH2 at 5.4 on Friday. Now, when the client says “MATE, that’s an awful market!” we can respond with, “The supply chain is broken mate.”
There have been comments about the timing of the Omicron leak, on Thursday afternoon when US markets were closed. However, last Monday there were fairly strong warning signals with Austria reverting to lockdown and Merkel saying “We are in a highly dramatic situation. What is in place now is not sufficient.” The Fed has always used Covid as a caveat in terms of policy, and of course this new variant could cause a slight shift. However, I think taper is still on schedule, given last week’s plunge in Jobless Claims to 199k and Core PCE prices rising 4.1%, the highest since the early 1990’s. In fact, this is PERFECT for the onset of taper. The market is demanding the safety of treasuries going into year-end, just as the Fed lessens its bid at the margin. Net zero.
Of course, in the bigger and longer time-frame picture, things aren’t perfect. The purpose of QE is to push investors out on the risk spectrum. It succeeded fabulously, to the point of creating the illusion of no risk at all. But a day like Friday injects a much needed dose of fear. If the Fed overtly responds by changing taper plans, then it’s back to moral hazard in an environment where price increases have already taken central bankers by surprise. We’ll get a hint on policy Tuesday, when both Yellen and Powell are slated to testify about the CARES Act. Clarida also on tap Tuesday, ironically enough discussing Fed independence. (Central bank independence in Mexico is under a cloud with Obrador unexpectedly naming Victoria Rodriguez as the head of Bank of Mexico; the peso weakened to 21.92, the lowest of any of the years of Trump’s presidency aside from 2020 covid; the peso is at a new low for 2021).
Here are a couple of prices of things related to the new and improved covid variant. Peloton (PTON) the ultimate stay-at-home laundry rack gym machine, bucked the trend and rallied on Friday, surging 5.7% to 46.41. Of course, at the start of the year it was north of 160, so perhaps a new lockdown isn’t being as aggressively priced as it was in the past. But here’s a price that might have much large ramifications. March Corn traded down with all the other commodities on Friday, putting in a low of 572. However, it closed at 591 ¾, just off the day’s high, the highest settle in that particular contract since July. On Tuesday, the NY Fed is presenting a virtual event on food insecurity (Williams is speaking). From the NY Fed website:
The event is part of the New York Fed focus on three areas affecting community development: household financial well-being, climate-related risks to low- and moderate-income communities [huh?!], and the social determinants of health. One of the key social determinants of health is consistent access to nutritious food.
Now I personally have a soft spot for the last point as my sister developed a grass-roots, nonprofit program to teach kids about gardening and healthy foods: Healthy Foods for Healthy Kids. Donate $20 and get my stuff for FREE!: https://healthyfoodsforhealthykids.org/
My point is that climate and urban food supplies might not be the main thing the NY Fed should be focused on. On the other hand, global food supplies are critical. When President Xi instructs energy suppliers in China to acquire sufficient inventory at any price, think about food needs across the planet. I ran across an article on Russia’s possible incursion into eastern Ukraine and though I doubt there would be any impact, Ukraine is a large wheat exporter of about 23 million mt out of 33 million mt produced (about 4% of global supply). Russia is the largest wheat exporter at 75 mt and is expected to introduce grain export quotas in December. Food security is critical, and supplies may become much more expensive.
On Wednesday, we have Mfg ISM and the Beige Book for the December 15 FOMC. Friday brings the Employment Report, with Non-farm payrolls expected 530k. Highlight will likely be Tuesday testimony by Powell and Yellen.
OTHER MARKET THOUGHTS / TRADES
Obviously, this was a brutal option expiration in December treasuries. On Wednesday, TYZ 129.75 straddle settled 21/64’s vs 129-26+. On Friday the contract settled 131-05+, the call settled to futures at 1’27. Option markets were pretty much unavailable on Thursday evening, so there was really no out.
Therefore, markets likely stretched too far on Friday. Although there is quite a bit of fear-mongering about Omicron, some are dismissing a long-term impact. In treasuries, there is likely to be a retracement of part of the move, though risk-off seems prudent going into the end of the year. As of this writing on Sunday morning, bitcoin has not really seen a bounce, though it’s stable at 54295.
A friend in energy markets has mentioned to me that there’s been a consistent seller of CL 65/55 put 1×2’s. Taking a credit to sell 2x the 55 put vs buy 1x the 65 put. Protected all the way down to the 45 strike and even lower with the credit. At least, that’s how it’s SUPPOSED to work. Until you get a move like Friday’s. On October 14 as CLZ2 was 72.61, the settles were CLZ2 65p 7.51 and 55p 4.58. a credit of 1.62 on the trade. On Friday the settles were 12.46 and 7.96. a credit of 3.46 vs 63.98. Things moved a little faster than indicated by “the model”.
| 11/19/2021 | 11/26/2021 | chg | ||
| UST 2Y | 54.7 | 51.6 | -3.1 | |
| UST 5Y | 121.7 | 117.9 | -3.8 | |
| UST 10Y | 153.6 | 148.3 | -5.3 | |
| UST 30Y | 190.7 | 182.9 | -7.8 | |
| GERM 2Y | -77.8 | -75.6 | 2.2 | |
| GERM 10Y | -34.2 | -33.5 | 0.7 | |
| JPN 30Y | 67.9 | 67.3 | -0.6 | |
| CHINA 10Y | 292.8 | 285.8 | -7.0 | |
| EURO$ Z1/Z2 | 72.0 | 67.2 | -4.8 | |
| EURO$ Z2/Z3 | 65.0 | 68.0 | 3.0 | |
| EURO$ Z3/Z4 | 16.0 | 16.5 | 0.5 | |
| EUR | 112.81 | 113.18 | 0.37 | |
| CRUDE (active) | 75.94 | 68.15 | -7.79 | |
| SPX | 4697.96 | 4592.62 | -105.34 | -2.2% |
| VIX | 17.91 | 28.62 | 10.71 | |
https://www.ft.com/content/ede12db9-0261-4c7e-8f6f-b61de57b2383
