June 3 (Weekly). The China Syndrome
Political turmoil in Italy sparked a big risk-off reaction at the start of last week, but by late Friday things stood pretty much as they were the previous Friday. The largest net change on the US curve was the 30 yr yield, which fell just under 5 bps to 3.045%. If one had no other information than the weekly changes shown on the table at the bottom of this note, he might surmise that the $2 drop in crude oil diminished inflationary threats, causing a slight bull flattening move while providing support for equities. Indeed, stocks ended the week with a powerful rally. The Russell 2000 closed at new all-time highs, while the Nasdaq is within 1% of a new high, having surged 1.5% on Friday alone. VIX closed the week at 13.46 from 13.22 the previous Friday. With Italian banks and Deutsche Bank (added to a list of problem banks in the US) under heavy pressure amid worries that euro-skeptics are gaining political power, the euro actually closed up slightly on the week. This, in spite of solid, dollar-supportive data. Friday’s payroll number featured yoy Average Hourly Earnings +2.7%, while Thursday’s Mfg ISM included the highest Prices Paid component since 2011. There was also a rather bearish speech from former Fed dove Lael Brainard (more on that later). In fact, on a technical basis, the euro tested the 50% retrace from the 2017 low of 1.0341 to Q1’s high of 1.2555. 50% is 1.1448 and Tuesday’s low was 1.1510; late Friday it was 1.1659, up from last week’s 1.1645.
With the sweep of broad perspective, our current environment might be framed as the age old paradigm of man vs machine, or ‘simple model’ vs ‘nuanced human decision making’. The machine takes the data as presented. A new low in 2/10 treasury spread at 42 bps, combined with a drop in oil prices derives compressed term and inflation premium. Therefore, buy stocks. Technical level held in EURUSD, buy euro. The intricacies of Italy’s politics are unimportant inputs in the equation. This is one of the main themes in Michael Lewis’ fascinating book The Undoing Project, where time after time, in sports, in medicine, in battle, in trading, a simple model provides better results than expert human analysis and guidance. It’s an idea the Fed has constantly fought against.
This week I watched The China Syndrome a classic 1979 movie about a nuclear power plant accident. The title refers to a core radioactive meltdown event which theoretically could blow right through the planet to the opposite side, China. All of today’s themes are touched upon in this movie: sexism, technology vs human intervention, corporate greed, fake news. The power plant control room, where Homer Simpson works, is full of analog dials, manual switches, and whirring tapes. There’s one scene where the controller has to tap the window of an instrument to unstick the mechanical needle which identifies a crucial piece of data, the water level surrounding the core. This movie was made even more famous by the fact that its release was just a couple of weeks before the Three Mile Island nuclear plant accident in PA. It’s no Barbarella, but it does star Jane Fonda as the sexy human-interest reporter trying to transition to ‘hard’ news. Her camera news team is doing a routine feature story on nuclear power at the plant, when they witness (and clandestinely film) an accident. The technology transformation has been incredible, on many levels.
The machines and models have also, of course, transformed the trading business. In our movie example, the shift supervisor panics about overloading the plant for fear of catastrophic mechanical failure. On Tuesday, the CME handled the overload flawlessly, trading a record 51.9 million contracts. The CME press release, linked below, notes that “six of the company’s ten highest volume days have occurred during 2018 to date.” No China Syndrome. We had a tremor in the system early in the week, but no ‘flash crash’. As Jack Lemmon says (early in the movie) “the systems work.”
However, open interest in eurodollars, and in other interest rate products, suggests that the system is powering down to some extent. The chart below shows one representative Eurodollar contract, the 9th quarterly or first green, now EDM20, overlaid with aggregate open interest in all ED contracts. At quarterly expirations, there’s typically a large drop in open interest, which is then replaced with new hedges/positions. From the start of 2018 as the tax package was passed and estimates of forward growth were ratcheted up, ED open interest screamed higher, moving from 12.5 million to nearly 18 million, a jump of nearly 50%. New positions were placed on the prospects of a more aggressive Fed spurred by sustained, fiscally-driven growth. However, after the March expiration, open interest fell and rather than re-building, it has continued to decline to more typical levels. The same phenomenon, to a lesser extent, is apparent in treasuries. My interpretation is that the market lost the concern that rates would continue to press higher, and views fiscal stimulus as one-off. This is corroborated by the flattening in the back end of the curve, where the red/green euro$ pack spread ended the week at 8.625, right where it started the year (with an intervening high just shy of 22). Green/blue ended at 2.5. The rally of the past two weeks was particularly unkind to shorts, who ran for the exits.
Brainard’s speech (link below)
Lael Brainard is one of the last of the old guard on the Fed board. She had been dovish during Yellen’s tenure, but has recently modified her outlook. In her speech last Thursday, she said the economy is growing above trend and that she expects tailwinds from fiscal stimulus in the second half and beyond, concluding that “continued gradual increases in the federal funds rate” are appropriate and will move “after some time, modestly beyond neutral.”
She briefly talks about risks, specifically citing ‘political developments in Italy’ and further says ‘some emerging markets may find conditions more challenging.’ Indeed Italy 5yr CDS zoomed up in May from 70 to 270, nearly catching up to Turkey, which reached just under 300 bps at the end of May. Italy ended the week at 219…still rather elevated. For the most part though, risks are glossed over in a short paragragh.
She spends more time on the relatively flat curve and cites a decline in term premium, which was partially engineered by the Fed, as one of the main culprits for the flatness. In other words, Brainard more or less dismisses signals from the curve at present. A week and a half in front of June’s FOMC she notes “…I believe that the forward-guidance language in the Committee statement that was introduced a few years ago that ‘the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run’ is growing stale and may no longer serve its original purpose.” This is a clear signal that language is likely to change at the June meeting. Ironically, such a change may actually provide added pressure on the curve.
News is fairly light this week with Factory Orders and Durables on Monday, ISM Serices Tuesday. On Thursday the Fed’s Z.1 report comes out which updates Household Net Worth and Debt levels of the various sectors.
| 5/25/2018 | 6/1/2018 | chg | |
| UST 2Y | 247.8 | 246.5 | -1.3 |
| UST 5Y | 276.3 | 273.6 | -2.7 |
| UST 10Y | 293.3 | 289.1 | -4.2 |
| UST 30Y | 309.3 | 304.5 | -4.8 |
| GERM 2Y | -62.2 | -62.8 | -0.6 |
| GERM 10Y | 40.6 | 38.6 | -2.0 |
| JPN 30Y | 73.6 | 71.4 | -2.2 |
| EURO$ Z8/Z9 | 33.5 | 31.5 | -2.0 |
| EURO$ Z9/Z0 | 7.0 | 6.0 | -1.0 |
| EUR | 116.45 | 116.59 | 0.14 |
| CRUDE (1st cont) | 67.88 | 65.81 | -2.07 |
| SPX | 2721.33 | 2734.62 | 13.29 |
| VIX | 13.22 | 13.46 | 0.24 |
https://www.federalreserve.gov/newsevents/speech/brainard20180531a.htm
