The Equalizer
March 6, 2022 – Weekly comment
My brother was looking to buy an equalizer for his stereo system. I don’t even know what an equalizer is. I saw the set up when I went over to his place. Four foot tall speakers, a rack with a tuner, the equalizer, a turntable, stacks of vinyl. I posted an article some years back about how much modern technology has displaced physical things. It was fascinating, an i-phone that fits in the palm of one’s hand replaced all the stereo stuff, telephones and answering machines, alarm clocks, video players, even desktop computers. Pounds of plastic, metal, glass and wires. But the i-phone is completely dependent on the integrity of the internet. Neil Young not on Spotify? I’ve got the Harvest album right here.
There are just a few themes I am covering this week, mostly through charts. I’m starting with an old one which relates to things you want versus the things you need; a constant thread in my conversations with DK. There are now shrill warnings about upcoming shortages of energy, food, fertilizer, computer chips.
Since the GFC, it’s all been financial engineering of paper assets over physical commodities. Facebook and video games instead of bicycles. If Ukraine has shown us anything, it is how it can all stop on a dime and reverse. This chart shows the resurgence of commodities.
Often we hear people talk about money flowing from one sector to another as if it’s a constant. Sometimes money just disappears. It doesn’t “flow” anywhere. It evaporates. Then those commodities that heat our homes and physically transport us and feed us become quite precious. I heard a comment on a Gavekal interview which I thought was pretty insightful and I am paraphrasing “Almost all economic activity is energy transformation in one way or another.” In this week of the Ukraine conflict CLJ2 (WTI crude) rallied 26% to $115.68/bbl. May Wheat rose 40+ %. According to an article in Wired about half of the world’s supply of neon gas comes from Ukraine.
Among Putin’s first targets was Odesa, a seaside city huddled around the Black Sea, and one of the country’s busiest ports. But it is also home to a little-known company called Cryoin, which plays a big role in the global production of semiconductors.
Cryoin makes neon gas, a substance used to power the lasers that etch patterns into computer chips. It supplies companies in Europe, Japan, Korea, China, and Taiwan, but most of its neon is shipped to the US, the company told WIRED. Now analysts are warning that the ripple effects caused by disruption to Cryoin’s supply could be felt around the world. WIRED Feb 28
The information technology that the world has taken for granted could be vulnerable, not just due to another round of chip shortages but due to cyber attacks.
Another chart below shows the historic inversion of the red pack to green pack on the Eurodollar curve. The reds are the four quarterly contracts one year forward, and the greens are the four quarterly contracts two years forward. On Friday, the red pack, which is just a simple average of the 4 contract prices (EDH3, M3, U3, Z3), settled at 9794.5 or 2.055%. The green pack settled 9815.625 or 1.84375%. The inversion on this part of the ED curve is at a historic low. Typically, an inversion occurs near the end of a tightening cycle (shaded areas), as the chart below shows:
The white line is the red/green pack spread which settled right around -21 bps on Friday. You can see that it has ranged from slightly negative to about 145. Shaded areas are tightening cycles – that’s typically when the red/green pack spread accelerates to the downside. The decline in 2011 was associated with the assault on the euro and widening of peripheral spreads in Europe…tighter financial conditions. It’s also apparent that inversions are related to tops in stocks. The brief tightening cycle in 1999 was a belated response to the dot.com bubble, and red/green bottomed with the end of that cycle (which, by the way, featured FF at 6.5%). The 2004/2006 tightening cycle culminated with the mortgage crisis and GFC. The extended 2015 to 2018 cycle featured the brief 20% drop in SPX in Q4 2018. Now equities are significantly higher, with market cap to GDP starting this year at a historic 200%. The only question is whether the current stock pullback is something brief like 2018 or more protracted like the early 2000’s or 2007 to 2010. I had never thought that monetary policy could “fix” the covid crisis. I was wrong. The Fed certainly ameliorated the pain. I now don’t think that monetary policy can fix a global military conflict. The enormous monetary and fiscal injections into the covid economy have led to inflation. Presently, any monetary policy moves to plug the gap in frozen payment chains will inevitably be viewed through the prism of inflationary impulses.
Lest one thinks this ED curve inversion is simply due to the libor to sofr transition, I would note that the red/green ED pack spread went from +60 last October to -20 now, while the red/green SOFR pack spread went from +63 in November to -7.75 now. It may be slightly accentuated in dollars, but the dynamic is the same.
Not only that but the inversion is moving closer in time. All one-year calendars had been settling in positive territory until December. In the beginning of Dec 2021, as Powell articulated his hawkish shift in late November, EDH4/EDH5, M4/M5 and U4/U5 all went slightly negative, bottoming on Dec 3 with EDU4/EDU5 the lowest at -3.5. So that inversion was 2.5 to 3 years forward. Now the nadir is -26.5 (EDM3/M4 and U3/U4) with the first inversion now EDH3/EDH4 at -6.0, which is only one-year forward. This tells you that the danger of recession is drawing ever closer, like the cartoon damsel strapped to the conveyer moving toward the logging saw before being rescued by Dudley Do Right.
The last two charts are related to credit risks. Is it any wonder that surges in commodities like wheat and oil are leading to a surge in the price of near-term funding? I suppose the surprise might be that the rise in credit spreads is relatively muted, owing of course, to the idea that the Fed will intervene. First chart is Hi Yield CDX five year spread, which has jumped 100 bps since the start of the year.
The second chart is the spread between 3-month EDH2 eurodollar contract to SFRH2 3-month SOFR. This spread has jumped 30 bps since early Feb.
It’s not a huge week for economic reports, though CPI is released on Thursday. The last yoy 7.5% reading left a mark, but it’s expected to be 7.9% this time around, with many looking for an 8 handle. Ouch! The Fed’s Z.1 report which includes all sorts of debt statistics, but is cited by the press for the section on Household Net Worth is also released on Thursday. This latter statistic was $144.7 trillion in Q3 2021, and will probably edge to a new all-time high for Q4 (which will mark the top for some time to come). Auctions of $48b in 3yr on Tues, $34b 10’s on Wednesday and $20b 30’s on Thursday (10 & 30 are re-openings).
OTHER MARKET THOUGHTS/TRADES
Straddles are at extreme levels in Eurodollars. Here are a few examples. Notice the explosion in front straddles relative to backs. Fully one month of time value has passed on the table below.
| EDM2 | strike | straddle | |
| 2/4/2022 | 9895.5 | 9900.0 | 31.00 |
| 3/4/2022 | 9876.5 | 9875.0 | 49.50 |
| EDM3 | |||
| 2/4/2022 | 9802.0 | 9800.0 | 86.50 |
| 3/4/2022 | 9789.0 | 9787.5 | 112.50 |
| 0EM2 | |||
| 2/4/2022 | 9802.0 | 9800.0 | 48.50 |
| 3/4/2022 | 9789.0 | 9787.5 | 64.00 |
| 2EM2 | |||
| 2/4/2022 | 9787.0 | 9787.5 | 48.50 |
| 3/4/2022 | 9815.5 | 9812.5 | 53.50 |
| 3EM2 | |||
| 2/4/2022 | 9784.5 | 9787.5 | 47.50 |
| 3/4/2022 | 9823.0 | 9825.0 | 50.50 |
| TYJ2 | |||
| 2/4/2022 | 126-21 | 126.5 | 1’56 |
| 3/4/2022 | 128-17 | 128.5 | 2’06 |
| 2/25/2022 | 3/4/2022 | chg | ||
| UST 2Y | 158.4 | 149.0 | -9.4 | |
| UST 5Y | 188.3 | 163.2 | -25.1 | |
| UST 10Y | 198.3 | 172.2 | -26.1 | |
| UST 30Y | 229.3 | 214.7 | -14.6 | |
| GERM 2Y | -37.7 | -73.0 | -35.3 | |
| GERM 10Y | 23.1 | -6.9 | -30.0 | |
| JPN 30Y | 92.4 | 84.2 | -8.2 | |
| CHINA 10Y | 278.9 | 282.4 | 3.5 | |
| EURO$ H2/H3 | 146.8 | 117.5 | -29.3 | |
| EURO$ H3/H4 | 14.0 | -6.0 | -20.0 | |
| EURO$ H4/H5 | -13.5 | -14.0 | -0.5 | |
| EUR | 112.73 | 109.35 | -3.38 | |
| CRUDE (active) | 91.59 | 115.68 | 24.09 | |
| SPX | 4384.65 | 4328.87 | -55.78 | -1.3% |
| VIX | 27.59 | 31.98 | 4.39 | |
https://www.wired.com/story/ukraine-chip-shortage-neon/
