Propensity for self-destruction
February 20, 2022 – Weekly comment
When I awoke, I suddenly understood that this propensity for self-destruction was not an abomination, not something to be ashamed of or abhorred; it was our greatest strength. We turn the gun on ourselves not because we are more indifferent and less cultured than the British, or the French, or the Italians. On the contrary. We are prepared to destroy that which we have created because we believe more than any of them in the power of the picture, the poem, the prayer, or the person.
The above passage is from the novel A Gentleman in Moscow; it’s a powerful conclusion describing the Russian psyche, shared by Mishka Fyodorovich Mindich with Count Alexander Ilyich Rostov. Mishka cites several events leading to this distillation, foremost being the burning of Moscow in 1812.
“Can you imagine the expression on Napoleon’s face when he was roused at two in the morning and stepped from his brand new bedroom in the Kremlin only to find that the city he’d claimed just hours before had been set on fire by its citizens?” Mishka gave a quiet laugh. “Yes, the burning of Moscow was especially Russian, my friend.”
I’m not sure that I want to inform my view of world events unfolding in Russia/Ukraine by musings in a novel, but I sure as hell wouldn’t dismiss this characterization. The propensity for self-destruction runs a full spectrum from fiercely noble to pityingly pathetic. Let’s move towards the latter with a discussion of markets.
In many ways, Bullard’s doubling down on calling for a 50 bp hike in March and 100 bps by July (Monday) marked the peak destructive fear in rates. This was most evident in the short end. On Monday, EDH2/EDH3 one-yr calendar made a new high of 144.75, and just slightly eclipsed that level on Tuesday at 145.25 before ending the week at 137. April Fed Funds, which price odds of the March hike, settled at a low of 9947.5 on Feb 10, and 9951.0 on Monday, Feb 14. On Friday this contract settled 9960.5, closer to 25 than 50. (A 50 bp hike equates to 9942 and 25 bps to 9967). Both 2/10 treasury spread and red/gold Eurodollar pack spread posted their lowest settles on Friday: the former at 40.7 and the latter at negative 11.5. By Friday, both had rebounded about 5 bps, to 45.6 and -4.75.
Full-blown panic was shown in ED straddle levels. For example, on Monday Feb 7, the at-the-money straddle on EDZ2 was the 9837.5 strike which settled 63.0. On Monday, Feb 14, the atm straddle was the 9800 strike at 85.5. This is a huge level with breakevens at 9885.5 and 9714.5. By Friday we had drifted upward to a price of 9817 and the 9812.5 straddle was down to 70.5.
As the week progressed there appears to have been a subtle shift from the idea of aggressive rate hikes to slightly more emphasis on balance sheet reduction. The head of the NY Fed, John Williams, on Friday said he didn’t see a compelling reason for taking “a big step at the beginning.” (BBG) For balance-sheet reduction, Williams said it can happen more quickly and sooner relative to liftoff than it did after the last cycle. Also on Friday, Lael Brainard voiced support for rate hikes and added that it’s appropriate to begin balance sheet runoff. Williams’ speech also noted that fiscal policy will no longer provide an economic boost and that other central banks are in the process of removing accommodation.
From JPM economists led by Bruce Kasman, “We now look for the Fed to hike 25bp at each of the next nine meetings, with the policy rate approaching a neutral stance by early next year.” There are seven meetings until the end of this year. That would be 175 bps of tightening according to JPM’s schedule. Jan 2023 FF are 9843.5 or 1.465% indicating 5 or 6 hikes. In 2004 to 2006 the Fed hiked at every meeting starting June 30, 2004. On June 29, 2004, just at the onset of tightening, the ten year yield was 4.68%. From that time until March 2006, the ten year yield never got above that point, mostly ranging from 4.6% to 4%, with a dip to 3.88% in May of 2005. By the way, by May 2005 the FF target had been raised to 3% from the initial starting point of 1%. So the FF rate went up 200 bps and tens never really moved…part of the conundrum cited by Greenspan. However, there was ALWAYS positive carry.
In the current situation, June 2023 SOFR future is 9807.5 or 1.925%. The ten year treasury yield ended Friday at 1.93%. I’m not looking at the forward ten-year rate, but the point is that by next year there may be NO positive carry. As was included in the FOMC minutes last week: “…some also noted that SOMA redemptions would require significant adjustments to private-sector balance sheets, as investors absorb the net increase in Treasury and agency MBS issuance to the private sector, and money markets transition to lower levels of liquidity, and that these adjustments could take some time.” My view is that a positively sloped curve encourages private sector absorption of securities, and that the Fed should be cognizant by allowing the long-end do some of the heavy work in terms of slowing economic activity and thus stemming inflation. For example, the mention of the Fed primarily holding treasuries and reinvesting MBS coupons into treasuries could help raise mortgage rates and slow housing price increases. I believe that’s part of the reason the Fed’s focus is slowly shifting to the balance sheet as a tool of monetary restraint.
The other section that struck me from the minutes is this:
The staff provided an update on its assessments of the stability of the financial system and, on balance, characterized the financial vulnerabilities of the U.S. financial system as notable. The staff judged that asset valuation pressures remained elevated. In particular, the forward price-to-earnings ratio for the S&P 500 index stood at the upper end of its historical distribution; high-yield corporate bond spreads and the excess loan premium for leveraged loans remained at low levels; and house prices grew strongly, with price-to-rent ratios that were at elevated levels. The staff noted that the market capitalization of crypto-assets had grown significantly over the past decade and had experienced considerable volatility, including sizable declines since late last year.
“Notable financial vulnerabilities.” The warning isn’t particularly shrill, as other risks were deemed ‘moderate’. On the other hand, there’s this: “…some available measures of hedge fund leverage continued to increase, and important data gaps continued to limit a full assessment of vulnerabilities posed by many nonbank financial institutions.” This is the sort of ‘after-the-fact’ sentence that staff can point to and say, “Well it’s not as if we didn’t warn you!” From Credit Bubble Bulletin: “Bernanke’s coercion of savers into risk markets created a dynamic whereby the markets would become only more integral to the system of financial conditions, perceived wealth, and economic performance.” It’s a feature that the Fed seems to downplay.
This week we have several Fed speakers, mostly on Thursday: Barkin, Bostic, Mester and Waller. On Friday is the Fed’s preferred measure of inflation, PCE prices, expected 6.0% yoy from 5.8%, with Core 5.1 vs 4.9. U of Michigan Consumer Sentiment is also released. I don’t pay much heed to confidence surveys, but the decline in this one has been stark, from over 100 just before Covid to 61.7 last, which is approaching the GFC nadir of 56.4.
OTHER MARKET THOUGHTS/TRADES
The BBG Commodity Agricultural Index ended the week at a new high. I guess it’s just coincidence, but from the time the Fed adopted FAIT (flexible average inflation targeting) this index is up 88% or 62% annualized. Of course, it’s not just grains that have run, but almost all commodities. Maybe that’s why Fed officials conspicuously omit references to FAIT in recent speeches.
As FT’s John Dizard notes: EU farmers have already been suffering from a 549 pct rise in natgas prices, which has translated to a 263 pct rise in fertilizer costs. He adds, “Europe has great technology strengths, but gas and fertilizer do not come from a virtual reality headset. Russians had a strategy, and they have executed it.”
Again, from A Gentleman in Moscow: “Emile placed bread and salt on the table – that ancient Russian symbol of hospitality.”
It’s not virtual reality. It’s reality.
| 2/11/2022 | 2/18/2022 | chg | ||
| UST 2Y | 150.0 | 147.4 | -2.6 | w/I 150.0 |
| UST 5Y | 185.1 | 182.4 | -2.7 | w/I 182.5 |
| UST 10Y | 194.4 | 193.0 | -1.4 | |
| UST 30Y | 225.4 | 224.9 | -0.5 | |
| GERM 2Y | -32.4 | -47.8 | -15.4 | |
| GERM 10Y | 29.7 | 19.2 | -10.5 | |
| JPN 30Y | 86.9 | 93.9 | 7.0 | |
| CHINA 10Y | 278.8 | 281.0 | 2.2 | |
| EURO$ H2/H3 | 139.5 | 137.0 | -2.5 | |
| EURO$ H3/H4 | 14.0 | 17.5 | 3.5 | |
| EURO$ H4/H5 | -12.5 | -11.0 | 1.5 | |
| EUR | 113.50 | 113.22 | -0.28 | |
| CRUDE (active) | 93.10 | 90.21 | -2.89 | |
| SPX | 4418.64 | 4348.87 | -69.77 | -1.6% |
| VIX | 27.36 | 27.75 | 0.39 | |
