May 20. Culling the Herd
I watched a riveting documentary on PBS the other day. I just happened to put on the tv and the program had already started, chronicling the life and discoveries of Dr Marian Diamond. From Wikipedia: Marian Diamond (nee Cleeves; November 11, 1926 – July 25, 2017) was a pioneering scientist and educator who is considered one of the founders of modern neuroscience. She and her team were the first to publish evidence that the brain can change with experience and improve with enrichment, a paradigm-breaking study that was the first hard data confirming what we now call plasticity in the brain.
The title of the show was My Love Affair with the Brain: The Life and Science of Dr. Marian Diamond (2016). In 1964 when she first released her findings that the brain’s composition can change and improve with environmental enrichment, she found hard set resistance by some scientists. Her research involved years of painstaking dissection, creating microscope slides for study and comparison. Such was her stature that she was allowed to take a part of Einstein’s brain for study in 1985, finding that he had a higher ratio of glial cells in relation to neurons than other brains. Of course, now we accept her discoveries on plasticity of the brain as common knowledge. The phrase, “Use it or lose it” may not have been coined by Dr Diamond, but it certainly became her rallying cry. Now in the new scientific realms of the internet and social media, we’ve moved on to more important topics like whether you hear “Yanny or Laurel”.
What does this have to do with Eurodollar options and markets? Not much. But recently, this pit has been the antithesis of ‘enrichment’. Amidst some of the most mind-numbingly boring days we’ve seen, the ‘use it or lose it’ mantra has taken its toll. I’ve found over the years, some of the most brilliant and crudely funny people I’ve ever met have been trading options on the floor. Now, with low vols and microscopic edge, some are leaving.
I might as well insert here one of my favorite theories on brain health, as know-it-all postman Cliff Clavin explained it to his drinking buddy Norm on the tv program Cheers (set in a Boston bar). “Well ya see Norm, it’s like this… A herd of buffalo can only move as fast as the slowest buffalo. And when the herd is hunted, it is the slowest and weakest ones at the back that are killed first. This natural selection is good for the herd as a whole, because the general speed and health of the whole group keeps improving by the regular killing of the weakest members. In much the same way, the human brain can only operate as fast as the slowest brain cells. Excessive intake of alcohol, as we know, kills brain cells. But naturally, it attacks the slowest and weakest brain cells first. In this way, regular consumption of beer eliminates the weaker brain cells, making the brain a faster and more efficient machine. That’s why you always feel smarter after a few beers.”
The week was not without interesting moves. New high yields were made in US ten and thirty year bonds, at 3.11 and 3.245. The combination of supply concerns, firming inflation, and waning CB support have finally conspired to slightly steepen the curve and make buyers more circumspect. Emerging market currencies continued to weaken and an index of EM FX (FXJPEMCS on Bloomberg) appears likely to test the low set during the energy market debacle of late 2015 early 2016. This was when front month WTI crude was $25/bbl; it’s now nearly 3x higher. EEM, the emerging market etf, is well off the high of the year but not quite through February’s low. In the energy induced sell-off in 2016, it traded a new low below 30. Since then it rallied to this year’s high just above 52 and is now 46. EMB, the Emerging Mkt bond etf, trades more like fx, and is making new lows. So there seems to be substantial divergence between EM fx/bonds and stocks/energy. According to a Bloomberg article, “Outstanding debt securities from developing nations have ballooned to $19 trillion from $5 trillion a decade earlier.”
On Tuesday, Franklin Templeton’s global bond fund, run by Michael Hasenstab, reportedly bought $2.25 billion of Argentine debt. I suppose those funds could have been put to an alternative use. Not only is EM debt under pressure, on Friday the Italy/Germany 10 year spread closed at the high for the year, 165 bps. Once again the idea of government borrowing “crowding out” the private sector may come into vogue.
So far, little stress has been noted in the US corporate bond market. A couple of weeks ago Louis Gave released a piece on liquidity and said that in 2008, the US had about $2.8T of corporate bonds outstanding, while dealer inventories totaled about 1/10th of that at $260B. Now the US corporate market is $5.3T, but dealers, due to regulatory changes, hold only $40B, a sliver of the outstanding market. Corporate bond etfs hold $300B. The point is that dealers are unlikely to cushion the fall, and when liquidity is most desired, it can disappear very quickly. As mentioned last week, corporate debt as a % of GDP is at a record high over 45%. According to the Fed’s Z1 report, TOTAL corporate debt as of the end of 2017 was $8.95T. A Bloomberg article (citing Wells) notes that companies will need to refinance an estimated $4 trillion bonds over the next 5 years. That’s easy in a yield-starved, low funding rate world, but might not be as simple going forward.
The current environment should make for a robust euro$ option market, with more reasonably inflated premium levels. Perhaps that’s just around the corner. For now, there are still large trades that get done at a price, for example a block buyer Friday of 60k 0EH 9675p 12.5, 36d covered 9693.0 (new). However, David Stein is again leaving the pit, and I’ve heard that some of the other market makers are paring back for the summer months. One of the European shops earlier this year decided to cease ED option activity due to lack of opportunity. Does this make a difference in a market that is increasingly institutionalized? Perhaps not, and maybe fewer players will be unnoticeable in a benign, low vol, environment. But if demand for insurance premium should pick-up, then size at a price may vanish.
For now, let’s wrap up the week with a couple of beers, and we can all start Monday with fresh, more efficient brains.
