Transitory Intermediation*
Weekly comment – June 27, 2021
On Tuesday, Cleveland Fed President Loretta Mester gave a speech on monetary policy and financial stability. On Thursday, the Fed released its report that the banking system had passed stress tests without a problem. Here is a quote from Mester:
There are several avenues through which the use of nonconventional monetary policy might create or contribute to financial system vulnerabilities. A commitment to a protracted period of very low interest rates could encourage risk-taking as investors search for yield; it could lead to a build-up in leverage; and it could lead lenders to lower their credit standards and promote increased borrowing. While all of these are avenues through which monetary policy typically affects the economy, the concern is that these effects could be excessive and create or contribute to financial vulnerabilities.
We have record high stocks, a booming housing market, shortages of skilled labor, the lowest junk bond yields ever and a ten year yield that can’t seem to hold much above 1.5%. A BBG article notes a record amount of IPOs in the first half of 2021 of $350 billion, exceeding the previous record of $282b in the second half of last year. Any excesses here? You just might be on to something Loretta. From Thursday’s green light for bank buybacks: “The Federal Reserve Board on Thursday released the results of its annual bank stress tests, which showed that large banks continue to have strong capital levels and could continue lending to households and businesses during a severe recession.” I suppose that’s why the Fed had to create at least eight emergency lending facilities and Special Purpose Vehicles for COVID.
The Fed is so confident about the resiliency of the banking system and the US economy that they’re afraid to taper and move rates from zero. Of course, they would still have to check with Larry Fink first.
Later in her speech Mester mentions, “Nonbank financial intermediation, through investment funds, insurance companies, pension funds…has risen over time. These entities now hold almost half of global financial assets up from 42 pct in 2008. This means that credit risk is increasingly being intermediated and held outside the banking sector.”
It’s pretty easy to conclude there’s froth in markets. BBG has another weekend piece discussing a pivot from “Peak Central Bank Support” and notes Bank of Mexico’s surprise rate hike last week and China’s continuing efforts to control debt. Obviously the Fed is making some small steps in that direction, and the market has responded by moving up the timing of rate hikes. As an example, the peak one-year Eurodollar calendar spread is now EDU’22/EDU’23 at 64 bps. The highest one-yr spread settlement of this cycle has been EDM’23/EDM’24 which settled 78 on April 5. It’s not really the case that this latter spread reflected an expectation of three 25 bp hikes, and that’s because of the libor cessation at the end of June 2023. Spreads that encompass that event are higher due to the transition to SOFR. However, for this rough analysis, it doesn’t matter. The point is that since the April 5 high of 78, EDM’23/EDM’24 has tailed off to 59, while EDU’22/EDU’23 is only 4.5 bps off its high settle of 68.5 on April 2. Let’s look at a few spreads since the beginning of April, when they were at the highs. I’ll use December contracts, since the Fed’s FOMC projections are end-of-year. (Table below)
Near one-year spreads aren’t at the peak, but they are at new highs for the year. EDZ’21/Z’22 is now 33.5, having started the year at 5.0. The next spread is EDZ2/Z3 which again, covers the libor transition, but it’s down 10 from the high of 71.5 in April. EDZ3/Z4 has tumbled 21.5 bps, with about ten of that coming after the FOMC meeting.
| EDZ1/Z2 | EDZ2/Z3 | EDZ3/Z4 | EDZ4/Z5 | |
| 2-Apr-21 | 28.0 | 71.5 | 65.0 | 40.5 |
| 25-Jun-21 | 33.5 | 61.5 | 43.5 | 25.5 |
| change | 5.5 | -10.0 | -21.5 | -15.0 |
One could make the argument that these spreads paint the case for Powell’s transitory inflation argument, in that the flattening of the back half of the curve is because expected inflation by that time will be lower than now. However, the corollary is that the market perceives lower future inflation because the Fed will be tightening sooner. For example, Rosengren said conditions for a hike by the end of next year could be in place soon, echoing other officials. Now it’s all about data and a slow-play by the Fed.
These spreads tell you about market perceptions of hikes both by levels and direction. New highs in near spreads suggest the end of next year is lift-off. I had thought the market might be more forceful in making the point that the Fed was ‘behind the curve’, and that’s why I’ve favored buying short Dec midcurve put spreads with EDZ’22 as the underlying. Example, 0EZ 9937.5/9912.5ps settled 5.25 Friday but was around 3 the previous week. Because of the dynamics between inflation and possible Fed actions, I have leaned more towards simply buying back month puts rather than forecast timing with futures spreads. I like blue midcurve puts (on EDU’24, EDZ’24, EDH’25) because I think inflation data will continue to worsen over the next few months, but that Powell will continue to play it down.
*And what does transitory intermediation mean? Nothing. Just sounds good.
Now for a detour into current affairs. A huge fossilized skull was found in China, possibly representing a new branch of the family tree. He’s been dubbed ‘Dragon Man’. From The Guardian: “The skull, which is 23cm long and more than 15cm wide, is substantially larger than a modern human’s and has ample room… for a modern human brain. Beneath the thick brow ridge, the face has large square eye sockets, but is delicate despite its size. “This guy had a huge head” said Stringer.
There was a broker on the trading floor, (and anyone who worked on the floor knows what’s coming next) who had a substantial head. The question, which was somewhat more worthy of serious consideration than other hypotheticals, was, “Would you rather have this guy’s head full of nickels, or a million dollars?” If Dragon Man had been discovered in those days, a broker would have sent a runner out to go buy a taper measure… “and make sure it has centimeters on it.”
OTHER MARKET THOUGHTS/TRADES
On Wednesday we have ADP, on Thursday ISM Mfg and on Friday, the employment report. Nonfarms are expected 700k which would be the highest level of the year excluding the March release of 785k. The CME has a full electronic session and a half day on Monday. Given a somewhat bearish response to Friday’s PCE price data, I think robust payroll numbers could really stick a fork in the bond market, especially in a thinly traded afternoon when most people leave early for holiday plans. I would consider buying week-2 (July 9th) US 155p for 5/64’s, which is where they settled vs 158-54. The low in the contract in May was 153-29, though the front June contract low at the time was 155-14. There is a minor trendline that come in around 156-00. This isn’t about targeting a particular level, it’s about the chance of a higher than expected number blowing up the market in thin conditions.
| 6/18/2021 | 6/25/2021 | chg | ||
| UST 2Y | 25.8 | 26.8 | 1.0 | |
| UST 5Y | 88.9 | 92.9 | 4.0 | |
| UST 10Y | 145.3 | 153.4 | 8.1 | |
| UST 30Y | 202.5 | 217.0 | 14.5 | |
| GERM 2Y | -66.6 | -64.7 | 1.9 | |
| GERM 10Y | -20.0 | -15.5 | 4.5 | |
| JPN 30Y | 67.4 | 67.4 | 0.0 | |
| CHINA 10Y | 314.2 | 309.8 | -4.4 | |
| EURO$ U1/U2 | 24.0 | 24.5 | 0.5 | |
| EURO$ U2/U3 | 61.5 | 64.0 | 2.5 | |
| EURO$ U3/U4 | 44.0 | 47.5 | 3.5 | |
| EUR | 118.64 | 119.38 | 0.74 | |
| CRUDE (active) | 71.29 | 74.05 | 2.76 | |
| SPX | 4166.45 | 4280.70 | 114.25 | 2.7% |
| VIX | 20.70 | 15.62 | -5.08 | |
