Nov 6. Underdog
You got no time for the messenger/ Got no regard for the thing that you don’t understand/You got no fear of the underdog/ That’s why you will not survive. -Spoon
“Ireland’s class of 2016 stamped their names into the history books as Joe Schmidt’s side dispatched New Zealand 40-29 in Chicago for their first victory over the All Blacks in 111 years of trying. Three days after the Chicago Cubs ended a 108-year drought to land baseball’s World Series, Ireland lit up the city’s Soldier Field stadium with their maiden win over the All Blacks at the 29th attempt.”
Utah, a friend of mine, reveling in Ireland’s defeat of the All Blacks in rugby said, “It’s the year of the upset! It’s the year of the longshot!!!” Certainly it’s been an historic week in Chicago with the Cubs Series win and the outcome of the match noted above. In a city usually cited for record murders, millions of people descended on the World Series parade route from Wrigley Field to Grant Park in Cubs blue, without incident. Train stations were mobbed, people were caught in gargantuan crowds climbing statues and lightposts, but the city came shining through.
On the political front, we (finally!) face the US election. Perhaps it’s not exactly the year of the underdog, but rather the year of the big middle finger, as shown by Brexit, and smaller examples like the Belgian region of Wallonia breaking the Canada-EU trade deal. Early next month the Italian referendum looms.
Where does it leave the markets? For one thing it means that trading survival depends on respecting the longshot and listening to the messenger (however muddled the clues might be). There hasn’t been follow through in markets this year, and central banks are intent on attempting to blunt the effects of any and all outliers. However, institutional powers are eroding.
I saw a bit of market commentary that said the markets gave us an indication this week of what a Trump win might do, as stocks eased lower and yields fell. According to my unscientific polling, most observers expect stocks to initially fall on a Trump victory. A Clinton win is viewed as ‘more of the same’. Of course, by many measures stocks are more than fully valued and are vulnerable no matter who ends up in the White House. However, this past week’s price action may have less to do with the election and a lot more to do with other factors. One of the big movers on the week was crude oil, which plunged nearly 10%, and is down nearly 15% from the high in mid-October. It was the hike last December and the plunge in oil prices which caused panic in high-yield and led to a drop in stocks (of over 10%) and rally in treasuries in the beginning of the year. From Barrons this week citing Martin Fridson, “Junk bonds have suffered a sudden and alarming selloff in the past two weeks. The 1.8% drop in the BofA Merrill Lynch U.S. High Yield Index since Oct. 24 works out to a minus 46% annualized total return, one of the most dramatic price swings of the past 20 years.”
The other often cited risk is China. Again from Barrons:
According to [DB chief internat’l economist] Slok, in 2015 it took more than $450 billion in bank credit to produce one percentage point of GDP growth in China. In the U.S., it took $350 billion to produce one percentage point of GDP growth at peak inefficiency in 2007. As recently as 2008, the amount of credit needed in China was less than half the 2015 number, before China amped up credit growth to levels never scaled by any major economy.
One of my themes has been that inflation data will start to accelerate due to yoy oil comps. The sell off in crude over the past few weeks diminishes this factor. I would note that in the odd market environment we find ourselves, two economically important commodities, oil and copper, are trading inversely; signals are crossed. However, yield curve measures continue to steepen. For example, 2/10 and 5/30 in treasuries, and reds/golds in euro$’s all closed near recent highs (99.3, 133 and 60.75). On the Eurodollar curve, butterflies generally declined, that is, near calendar spreads compressed relative to deferred as the market accepts the Fed’s idea of g r a d u a l hikes with a rise in inflation toward target. For example, Dec’16/Dec’17 ED one-year calendar fell 4.5 bps this week to only 15.0, while Dec’16/Dec’17 fell only 1 to 17.5, so that fly went from +1.0 to -2.5 this week. The front Dec/March spread, EDZ6/EDH7 closed at just 2 bps, a new recent low.
The employment report on Friday was supportive of a hike in December, as Fed Vice Chair Fischer summarized that the economy is close to full employment and that the labor participation pick-up is partially driven by wage gains. There was tremendous volume in EDZ6 on Friday of over 600k. But again, the signals aren’t particularly clear as open interest in that contract only changed by -4500. The first four ED contracts saw combined OI fall by 32k on Friday, but EDZ7, the 5th quarterly, rose by nearly 29k. The only obvious note is that some players are hedging bets for a December FOMC hike by buying calls and covering shorts in near contracts.
On the longer end, there was a new buyer of 70kTYZ 128 puts for 5 and 6/64’s. This put has a ten delta, and settled 6 vs 130-08. It’s about 25 bps out of the money, approx 2.04% on the current cash ten year. Note that the treasury auctions 3’s, 10’s and 30’s this week.
My personal bias is that yield curves will continue to steepen, and that even if Trump wins, the Fed will hike in December unless stocks fall >10% from here. I think there are low risk trades that can be entered for minimum premium outlay to express the idea that the Fed may be forced to be more aggressive in tightening next year than the market is currently pricing (call for ideas).
While this week’s focus is clearly the US election, shocks to the global system can come from many different directions, and risks globally appear to be growing. The VIX surged to above 22 from just over 16 this week, even though the decline in SPX was a rather modest 2%. Vol pullbacks across asset classes, should they occur, ought to be bought.
Finally, the mascot of the week. UNDERDOG!
when in this world the headlines read,
of those whose hearts are filled with greed,
who rob and steal from those who need,
to right this wrong with blinding speed,
goes Underdog! Underdog! Underdog! Underdog!
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| 10/28/2016 | 11/4/2016 | chg | |
| UST 2Y | 85.3 | 78.5 | -6.8 |
| UST 5Y | 132.3 | 123.7 | -8.6 |
| UST 10Y | 184.5 | 177.8 | -6.7 |
| UST 30Y | 261.6 | 256.7 | -4.9 |
| GERM 2Y | -61.7 | -63.7 | -2.0 |
| GERM 10Y | 16.7 | 13.5 | -3.2 |
| EURO$ Z6/Z7 | 19.5 | 15.0 | -4.5 |
| EURO$ Z7/Z8 | 18.5 | 17.5 | -1.0 |
| EUR | 109.87 | 111.41 | 1.54 |
| CRUDE (1st cont) | 48.70 | 44.07 | -4.63 |
| SPX | 2126.41 | 2085.18 | -41.23 |
| VIX | 16.19 | 22.51 | 6.32 |
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