May 27 (Weekly). At-the-money expiration and other thoughts
On Friday, at the noon strike (Chicago time), FVM8 settled 113-22, TYM8 119-275 and USM8 143-22. As the 4:00 pm bell was going off (in my head), TYM8 ticked 120-00. Late prints in FVM8 113-2425 and USM8 143-30, right at strikes. In treasury options, calls that expired worthless can be exercised manually, even after the close. So it’s worth taking a look at expiring open interest: FVM8 113.75c just 16k. TYM8 120c 107k, and USM8 144c 11k. On the put side TYM 120p had 62k open; while FV and US were similar to calls. A large manual exercise of TYM 120 calls could set off a brief buying spree; the shorts don’t find out if they’ve been exercised until it’s too late to do anything about it. I called the exchange late Friday to inquire about how many manual exercises went through… holiday voice mail. I wouldn’t be surprised to see an upside flurry at Sunday’s re-open.
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A couple of thoughts on EURUSD. Throughout 2017 into the beginning of 2018 the EUR generally strengthened (from 1.05 in Jan 2017 to 1.25 late Jan 2018) and of course, DXY weakened. Over the last month and a half, the dollar has strengthened, with many calling for further gains. In 2017, European data was coming out stronger than expected as the synchronized growth narrative gained traction. But the political situation in Italy has sharpened focus on credit concerns. Italy 5y CDS surged from 100 bps to 167 in the past couple of weeks. On Friday Moody’s said it may cut Italy’s Baa2 rating. Even Spain has jumped from 30 to 59. Of course, these levels are still relatively low; in mid-2013 they both were over 275 bps. However, the rapidity is quite unnerving. I would also note that Deutsche Bank closed at the lows (€ 10.38), and is now testing the low from 2016. The Italy bank shares index plunged 15% in the past week and a half. In light of these developments, there has been a repricing of odds for future ECB tightening. Decidedly lower. It’s informative to look at the forward curves in Euribor and Eurodollars. Below is a chart of red to green spreads in both ED and ER (2nd year to 3rd year). Perhaps unsurprisingly, throughout 2017 and into early 2018 the euribor spread was firming and the dollar spread was declining. This coincided with a weaker dollar. But since February, the euribor curve has flattened, dramatically this week, while the dollar curve flattened modestly. If one just looks at Dec’18/Dec’19 spreads, in the beginning of February, ERZ8/Z9 was 45 bps and EDZ8/Z9 was 36. In the past week and a half, the dollar spread went from 41 to 33.5, while in bor it plunged from 35 to 19.5. The crossover where the bor spread went to a discount was in late April, and that’s just when dollar strength commenced, as shown on the chart below. Top chart is Euro$ to Euribor red/green pack spreads. Lower chart is EDZ8/Z9 with ERZ8/Z9 with EURUSD in the lower panel.
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Now for a couple of thoughts on corporate credit quality. From Almost Daily Grants (May 25th) comes this:
Indeed, according to S&P Global Intelligence’s LCD unit, the ratio of “covenant-lite” loans rose to a fresh record of 82% in April, up from 20% in 2011. Christina Padgett, a loan analyst at Moody’s, struck a stoic tone, telling the Financial Times that: “There is no point in talking about financial covenants any more, or calling a deal ‘cov-lite’. They are all cov-lite. Cov-lite is the new normal.”
From John Mauldin’s Thoughts from the Frontline – High Yield Train Wreck series comes this: “Almost half of investment-grade companies are rated BBB, just one step above junk, up from just one-third in 2009.” Articles warning about deteriorating credit quality are pretty common, so I won’t delve into statistics. Bond spreads have barely widened. For example, the option adjust BBB spread is just 1.46%, less than half the high in the early 2016 energy debacle and only 30 bps above the low of the past five years, set earlier this year. I will though, hop on the WeWork bashing bandwagon that both Grant Williams of Things That Make You Go Hmmm, and Mauldin use as a poster child for absurd valuations.
WeWork leases large amounts of office space, carving it up into smaller pieces allowing flexible leases for smaller start-up tenants, and mixes in support and services. Not the most novel idea in the world, but the company was able to float a $700 million unsecured bond in April with a coupon of 7.875% (which fell below 93 cents to the dollar in the beginning of May).
One thing that caught my attention was a chart showing Independent Workforce as % of the Total Workforce in the US. (data apparently from WeWork). In 2008, 30% or 45 million people were categorized in this way. In 2014, 33% or 45 million people. The company’s estimate for 2020 is 40% or 60 million people. “The driving force has been the surge in freelancing and small business formation since 2008…” [I think the use of the word ‘driving’ also captures Uber freelancers]. One analyst, Credit Sights’ Jesse Rosenthal deemed the company’s “community adjusted” earnings number as “sketchy” and noted WW has “a massive asset/liability mismatch that is usually a recipe for disaster.” So what’s the problem? Only this: VALUATION. The market is valuing this company at $20B, far surpassing other established companies in this ‘space’. There were buyers into dreams and technology in the dot.com era as well, but shakeouts can be violent. I don’t know if WeWork is a great example, or if Tesla is more appropriate, but investors in these and other companies have bought into the vision of the leaders, Adam Neumann and Musk. There’s a quote in the Hmmm article, “Adam’s explanation for the [$20b !! ] valuation of WeWork speaks for itself.” Community and lifestyle.
A nation of freelancers and a world of cov-lite debt. Like a fortress right? This kind of reminds me of a conversation I was involved in long ago, with a sizable local in the heyday of Eurodollars and a couple of other pit guys. Kenny was incredulously saying that a family member was trying to give him money to ‘invest’ since he seemed to be so good at it. He might have been making a lot of money, but he laughed aloud at the notion that what he did was ‘investing’ and with a goofy grin he said he told his relative, ‘That’s not really what I do. Do you want some money? Because I can just give you some. Here. How much do you want?” (And he wasn’t making the offer sarcastically). Kenny had no illusions about his ‘investment and vision’ ability. But he did know he could walk out of the pit and go golfing in the summer at 9:30 am, so you might say he had the ‘lifestyle’ part lined up. In our current investment landscape, that’s what we’re buying into, heavy on the vision part.
It’s here that I’ll add a shameless plug for my friends Angela and Stel, who own a business called Creative Coworking with locations in Evanston and the north side of Chicago in the restored Colvin House mansion on Sheridan Road. They offer flexible communal leasing spaces for freelancers and start-ups and artists. And, you can rent out the opulent first floor for receptions. Sound familiar?
http://creativecoworking.com/
www.creativecoworking.com
OTHER MARKET THOUGHTS/ TRADES
Oil took a large tumble Friday, down over $3/bbl late (CLN8 settled 67.88, -2.83). The contract put in an outside week on heavy volume, which will likely limit upside from here. If EM couldn’t rally with stronger oil and other commodities, this move probably won’t help.
The release of Fed minutes last Wednesday that suggested IOER would only rise by 20 bps on a target FF hike of 25 bps sparked a strong rally in rate futures. Combining that with other factors concerning EM and the EU, odds for future rate hikes were trimmed. For example, Oct 2018 FF contract closed Friday at 9793.0 having traded as low as 9784.5 the previous week. While some of that move can be attributed to an expected decline in the Fed Effective rate, 6 or so bps can be chalked up to a less aggressive Fed. At 9784.5, odds of a Fed hike in Sept (after June) were around 80%. Now I would estimate a Sept hike at around 55%. The bar to skip a June hike in two and a half weeks is very high.
News this week could have some interesting ramifications in terms of inflation expectations. Wed brings a revision to Q1 GDP. More importantly, on Thursday PCE Core yoy prices are released, expected at 1.8 vs last at 1.9; edging away from target. On Friday the Employment Report is released with Avg Hourly Earnings expected +0.2, yoy 2.6%. Also on Friday is ISM, expected 58.1. The ‘Prices Paid’ component is expected 77.9 from 79.3 last, which was the highest since 2011.
| 5/18/2018 | 5/25/2018 | chg | |
| UST 2Y | 254.5 | 247.8 | -6.7 |
| UST 5Y | 289.2 | 276.3 | -12.9 |
| UST 10Y | 306.7 | 293.3 | -13.4 |
| UST 30Y | 320.9 | 309.3 | -11.6 |
| GERM 2Y | -58.4 | -62.2 | -3.8 |
| GERM 10Y | 57.9 | 40.6 | -17.3 |
| JPN 30Y | 76.0 | 73.6 | -2.4 |
| EURO$ Z8/Z9 | 39.0 | 33.5 | -5.5 |
| EURO$ Z9/Z0 | 8.5 | 7.0 | -1.5 |
| EUR | 117.71 | 116.45 | -1.26 |
| CRUDE (1st cont) | 71.48 | 67.88 | -3.60 |
| SPX | 2712.97 | 2721.33 | 8.36 |
| VIX | 13.42 | 13.22 | -0.20 |
http://www.mauldineconomics.com/frontlinethoughts/high-yield-train-wreck
