Nov 20. Past Performance is no Guarantee of Future Results
When I sent last week’s note, I thought it was a little ‘loose’, that perhaps I could have boiled down some thoughts and left others out, but on a re-read, I did mention a couple of things that worked out. Most notably, “Given the incredible shift in sentiment and the fact that positioning still needs to be adjusted, I think 235 to 240 is a reasonable level to attain prior to the next employment report”. I was referring to the US Ten Year yield, and that target was attained faster than I had thought, hitting 235 by the end of Friday. On this holiday weekend, I promised myself to shorten up the note, but there are many themes to address and I found myself wanting to include some old trading floor stories…
LeRoy Neiman CME print, loosely based on the currency quadrant.
This has been a very tough week for some, likely to be seared into mental trading history. Nothing burns into your brain like personal involvement in a bad trade, except, once in a while, a great trade. During the week I walked off the train with a friend who stands in the Eurodollar option pit. He was marveling at how some market making groups continue to accumulate the EDZ6 9900 straddle, even as we slide toward the strike…”well, yeah, this is better because I bought it 0.25 cheaper.” “Right, but now it’s offered 0.5 below that.” “So buy more…” In fact, earlier in the week we had reported that 6.25’s were trading, and a client immediately chatted back, “How’s it left?” I, of course, drew on my years of professional insight and said, “Still trading 6.25 but bid there, can I bid some for you?” “No. I am a seller.” Of course. Another impressive read on my part. It settled the end of the week at 5.0 vs 9902.5.
This reminds me of another story, which accounts for the pic of the currency quadrant above, which, amazingly enough was pretty vibrant at one time…pre-political correctness days. (There were a few good looking women in the d-marks there in the middle, can you see them? I can.) Anyway, a long time ago, there was a trader that used to call the floor to trade pound options (back in the upper left corner). At the time, all the banks had desks on the floor. This trader, known as The Sheik, started to sell a strangle, slamming the bid almost every day. I was on the other side of the floor in Eurodollars but everyone knew of the Sheik. He would call for a market and desks would frantically shout down for a quote, with NY desks buying the floor and pasting OTC bids. Of course, the pit market makers were also buyers. The pound gradually started to slide towards the put strike, but the Sheik continued to hammer the same strangle. Finally, it’s expiration day. The calls are worth nothing, the puts are maybe 20 pips out of the money, the Sheik calls for a market. Finally, he is going to buy these puts back! So the pit shades the bid slightly expensive. And of course, as the final indignity, the Sheik slams the bid, with the market ultimately edging a little closer to strike that day, but still worthless. I always take delight in that story when a friend who was in pound options at the time, tells it. You know, it’s delightful in the Conan “What is best in life?” way: “To crush your enemies, see them driven before you, and hear the lamentations of their women. That is good.” Of course, this isn’t even my favorite British pound story. That one involves Bino and Spootie, and I laugh to myself every time I think of it. Remind me and I will tell you when I see you, over a beer. https://www.youtube.com/watch?v=6PQ6335puOc
Moving from ancient history to the present….
Both yields and stocks closed on their highs. VIX went lower, treasury vol surged (chart below). Dollar Index at multi-year highs. Eurodollar one-year calendars all at new highs with the peak, March’17/March’18, at 45.5 bps, nearly ½%! UST 2/10 spread new high of 128, up 27 bps since the election. Ten year to bund yield soars to 206. BTP to Bund at the highest spread in two years at 182. Adjustments have been swift and severe. There are literally hundreds of things to talk about but I will briefly focus on a couple.
First, consider the end of 2013. Both the US ten year yield and the red/gold euro$ pack spread peaked ABOVE 300 bps. (Chart attached to email). 2/10 peaked at 264 at that time. This year, the ten year yield has rallied 100 bps off the low in July, post-Brexit, to 235, while 2/10 is up 53 from the low (to 128) and red/gold up the same magnitude, from 40.5 to 93.5. My question is, how can tens be only 65 bps from 3% while reds/golds are 206 bps away from the high three years ago? Just consider this: at the end of 2013, the gold pack was around 96.20 or 3.80% vs Friday’s close of 97.52625, or 2.47%. NOTE TO SELF: Don’t recommend buying any blues or golds unless you have a VERY compelling reason (or unless buying PUTS). Obviously there has been financial repression, and changes in the regulatory landscape, etc, which have tended to make the euro$ curve flatter than in the past. My intuition is that an adjustment back to previous history would have rather negative implications for credit. (think HYG and JNK).
Though I am not drawing any hard and fast conclusions about which trades should be entered, I am trying to determine which sorts of trades should be avoided, which is perhaps more important. So, here are a few more points which may help colorize this picture. First, we all know that Trump and Bannon plan to rejuvenate the manufacturing base with a trillion dollars (??) in spending. From BBG: “The president-elect’s pledges include tax cuts and spending $500 billion or more over a decade on infrastructure, a combination that’s seen as spurring quicker growth and price gains in the world’s biggest economy.” I am not sure of the amount, but I will say that at the height of the mortgage refinance boom in 2005-06, homeowners were extracting something like $600 billion at an annual rate from “home equity”. Now THAT was stimulus. Spending a trillion over several years might not have as much juice as one might think. That’s right, a trillion ain’t what it used to be (the bond market lost a trillion in value since the election), though I know, of course, there are many intangibles with new leadership.
I went back and reviewed a few figures from the Fed’s Z.1 flow of funds report to try to get a sense of stimulus. As mentioned above, the end of 2013 was when rates last peaked after the taper tantrum, with tens over 3%. From Q4 2013 to Q2 2016, Federal Gov’t debt outstanding went from $13.705T to $15.571T, an increase of 13.6%. Total business debt (Corporate being the majority), went from $11.293T to $13.223T, an increase of 17%. GDP went from $17.000T to $18.651T, an increase of just 9.7% over the same time frame (from St Louis Fed). My conclusions are as follow: 1) an increase in debt, in and of itself, hasn’t had a multiplier effect. 2) Corporate debt is at a nominal record $8.376T and we know a lot of that has gone to share buybacks. If leverage continues to outpace growth, possible credit problems lie ahead. 3) this isn’t a conclusion, but rather another salient point… in Q2 2015 the BAML BBB option adjusted spread was 180 bps. With the washout in oil and tighter Fed, the spread surged to just over 300 bps in the beginning of this year, in other words, financial conditions tightened. Now, it’s back to 180.
I am hopeful that the change in ‘animal spirits’ will spark growth. However, rates have probably gone up too fast for the time being and may churn around these levels for a week or two. Demand for the auctions this week (2’s, 5’s, 7’s) may provide clues as to whether this concession will draw strong bids. January Fed Funds are almost fully priced for a hike in December, and one-year Eurodollar calendars are close to projecting 2 hikes per year as they near 50 bps. Having said that, colleague TD reminds me that there aren’t that many trading days left in the year, conditions may become more illiquid, some adjustments may still need to be made. I don’t expect yields to continue their surge, but will be sensitive to the possibility. Also note that Dec Treasury options expire on Friday’s shortened session.
Finally I am attaching a chart of VIX versus TY vol. VIX is in white, treasury vol in orange. The spread, (lower panel) is about as narrow as it gets. Also, in many cases it appears as if treasury vol leads. Current circumstances given the election are much different than before, but it almost feels as if selling TY put spreads vs buying ES put wings might have merit.
I realize that some of the above thoughts can almost be thought of as contradictory, in keeping with the spirit of the President-elect. That’s why I started with the disclaimer right up on top.
Good luck this week and happy thanksgiving
