Notes From Underground: Riding High in April

In building on the discussions in Tuesday’s POST it is important to note that the debt discussion that has taken place in Notes From Underground is gaining traction as an important piece of the financial narrative. The failure of the SPOOS, NASDAQ, and DOW to gain traction with the robust earning releases is forcing the perplexed to confront the impact and collateral damage from Ben Bernanke’s Portfolio Balance Channel, also known as QE or large-scale asset purchases.

On Thursday we will hear from the two active indulgers of QE: the ECB’s Mario Draghi, followed by the BOJ’s Haruhiko Kuroda. There was an article on Zero Hedge on Wednesday that posited that the ECB was involved in a “stealth tapering” because of the fall-off in the ECB’s corporate debt purchases. At Draghi’s previous press conference, he advised not to watch FLOWS but to pay attention to STOCK of assets. Zero Hedge is suggesting that because a falloff in the amount ofcorporate sector purchase program (CSPP) that the ECB MAY be tapering.

I would argue that this is a low probability outcome because even though flows are smaller than the stock of assets on the ECB balance sheet, the size has increased. The problem with the ECB’s CSPP efforts is that the European corporate bond issuance is very small relative to the U.S. The European domestic banks are biggest source of corporate funding so the amount of investment grade credits is limited. The ECB’s impact on the supply of corporate credit was so significant that recently European high yield bonds were trading at a lower yield than U.S. Treasuries (another moment of insanity). Also, in picking up Draghi’s advice to “PAY ATTENTION TO THE STOCK OF PURCHASES NOT THE FLOWS,” I would offer this rebuttal to Zero Hedge: It appears that since the political uncertainty in ITALY, somebody has been buying large amounts of Italian 10-year notes, compressing the interest rate differential between the highest quality debt–French and German–even as Italy fails to alleviate the political stalemate in Rome.

My conjecture is that the ECB under Mario Draghi’s direction is actively building up its stock of Italian debt. This is in contravention of the ECB’s rules according to the capital key ratio. But as Mario the Magnificent has informed us, HE WILL DO WHATEVER IT TAKES. The ECB is expected to leave everything status quo but as I warn, watch the press conference which begins at 7:30 CDT. I am not expecting any change from the ECB as Draghi will be content that the EURO has been softening, which he will proclaim to be a positive because it will help stem the recent slowing in EU economic growth. There will be many questions about the end of QE in Europe but Draghi will remain noncommittal, especially as the BOJ’S Kuroda has been talking about the need to sustain the Japanese effort to meet a 2% inflation target.

The U.S. will continue to meet its quantitative tightening targets while also raising interest rates. Draghi will be happy to parody the Indian Chief in Blazing Saddles: LOSEM GEYN. NET RESULT: NO CHANGE FOR THE ECB or BOJ. In Japan, the biggest concern is the political uncertainty facing Prime Minister Abe. Will he be able to sustain his position in the face of corruption concerns? Governor Kuroda will resist any change to current monetary policy until the political uncertainty is removed.

***Outcomes from the rise in U.S. interest rates. There was a high quality discussion on last night’s POST concerning my reference to the breaking of the 3% barrier on the 10-YEAR NOTE. From a trading perspective, the 10-year yield was certainly going to set the ALGOS in motion but my desire was to clarify the move from 2.93% to 3.00% as MEANINGLESS in that the two-year note has risen above 2.5%, which was far more important. But the issue remains as to the effect of rising U.S. rates:

1. Very strong earnings have failed to sustain a significant equity market rally. There are growing concerns about the impact of future earnings from rising yields. This is combined with what some have called a higher hurdle rate for stocks because one-year TREASURY BILLS are yielding more than 2%.

2. GOLD prices have retreated over concerns of the flattening yield curve and U.S. interest rates heading toward positive real yields, which is always a hurdle for the metal. But this is why I have maintained that the GOLD story is a global central bank concern. I have advised being long GOLD against various fiat currencies. The GOLD/EURO cross is hovering around the 200-day moving average after having climbed above the level on the GOLD/YEN. The GOLD/YUAN has failed at the 200-day moving average as the Chinese YUAN has retained its strength against the U.S. dollar once it became clear that the Chinese would not seek to depreciate the YUAN in retaliation for U.S. tariffs.

The EURO, SWISS, YEN, POUND, CANADA, AUSSIE, KIWI have all weakened in the wake of the U.S. 10-year above 3%, but my response would be: WHAT TOOK YOU SO LONG? The interest rate differential on the short-end has made it very expensive to short the dollar as investors have to PAY AWAY more than 2.5% to be long euros/short greenback. The negative short-term cost of carry has forced some SHORT DOLLAR positions to be covered. Last year, investors anticipated such a move as most investment banks were publicizing a long DOLLAR perspective. However, the White House targeted unfair trading practices, which trumped dollar longs.

3. The issue raised last week about the Mexican peso. The underlying fundamentals of the Mexican economy are strong but the political situation was unsettling. AMLO and leftist presidential candidate Obrador’s recent rise in the polls have made investors nervous, especially after the televised debate. The peso has weakened even as there seems to be expectation of a positive outcome for the NAFTA negotiations. The PESO originally rallied into the news of a NAFTA compromise, but the polling strength of AMLO coupled with a rise in U.S. interest rates have weakened the Mexican peso.

The fundamentals will now be secondary to the politics but look for the U.S. to provide the current Mexican government with greater support in an effort to defeat AMLO. Even Ross, Navarro and Lighthizer understand political expediency. Okay, maybe not. So as April comes to a close we turn to the wisdom of Sinatra: That’s Life In the Global Macro World. Politics coupled with rising interest rates …

Some people get their kicks
Stompin’ on a dream
But I don’t let it, let it get me down
’cause this fine old world it keep spinnin’ around

Tags: , , , , , , , , , , , , , , ,

8 Responses to “Notes From Underground: Riding High in April”

  1. Philippa Dunne Says:


    • yraharris Says:

      Philippa–I am glad you posted but I can’t find what you wrote.I am sitting on your retail sales piece to make light of your analysis on the percentage of non financial corporations interest expenses as a percentage of corporate profits –it is so very telling but I need your ok

  2. asherz Says:

    “Very strong earnings have failed to sustain a significant equity market rally.”
    One should remember that in 1929 corporate earnings were strong. It was valuations that were extreme. Valuations today as measured by percentage deviations from historic norms are at highs. Another factor is looking at enterprise values and that higher debt reduces the value of the equity portion. So if debt moves from 50 to 60% of enterprise value, and there is no change in valuation, equity is reduced by the same percentage. Markets have given more value to equity despite rising debt, causing overvaluation and fragility. Volatility is now the norm after a long period of a low VIX. This is comparable to earth tremors before a quake or lava flows before an eruption.
    The Roaring 20s followed WW l. Euphoria ensued. The Fed began to raise rates at a time of low margin requirements and leverage and the market crash followed. Overvaluation and leverage.
    Central Bank QE following the Great Recession and again euphoria took over. The Fed by necessity is now raising rates and QT. We now have overvaluation and debt leverage. Strong earnings will not sustain higher equity markets. History can be a great teacher.

  3. Peter M Todebush Says:

    Mystery Bond Trader Makes Massive Bet On Transatlantic Yield Curve Reversal

    Shooter McGavin, Bond Trader Extraordinaire This afternoon some big shooter put on a monster U.S. steepening / German flattening bond block trade. The specifics of the trade were;

    buy 100,174 US five-year treasury futures
    sell 63,887 US ten-year treasury futures
    sell 65,362 German bobl futures (5-year)
    buy 29,145 German bund futures (10-year)
    The chart below shows the moment the block trade was struck at around 11:30am EDT: just then the U.S. curve steepened to session highs while the German curve flattened to the day’s lows.

    I did get a few pings asking if I was busy writing some tickets, but alas, the ‘Tourist’s positions have a lot less digits. According to Bloomberg, this massive position has $4.7 million of DV01 risk (dollar-value per basis point) signalling very strong conviction. That’s way above my pay grade, but it’s worth thinking about the rationale behind this whale’s trade.

    Let’s break the trade into two parts. The first is the US side. The trader bought the five-year US treasury future and sold the ten-year US treasury future. This half of the trade will profit if the U.S. treasury yield curve steepens between the 5 and 10 year portion of the curve.

    The trade was executed at around 18 basis points. But where does this stack up compared to recent trading?

    The curve has flattened like it’s Shrove Tuesday and we aren’t that far off the curve inverting. Let’s zoom out a little further and look at this spread through a couple of economic cycles.

    During the past two economic cycles, the 5-10-year area of the Treasury curve went negative for at least a brief moment. Yet so far this cycle, the negative print has eluded us.

    The trader executing this large bond trade is betting the U.S. 5-10-year spread will rise, but not in an absolute sense, only that it will gain more than the German 5-10-year spread.

    Here is a chart of the German 5-10-year spread.

    The German yield curve is much more positively sloped than the U.S. curve.

    The trader’s position can therefore be summarized as a relative bet on the two countries’ 5-10-year yield curve spread.

    Putting it all together, it’s designed to profit if the US 5-10 curve steepens more than the German 5-10 curve, or conversely if it flattens less. Either way, here is the chart of the difference between the two different curves.

    I suspect the U.S. yield curve is too flat, so I am partial to the American part of the trade. There is too much economic optimism built into the short-end of the US curve. This confidence has allowed the Federal Reserve to hike rates more quickly than any other central bank ove the past couple of years, sending the 3-month LIBOR from 0.25% to 2.36%.

    The risks are that the economic cycle is getting long-in-the-tooth and that in coming months, U.S. economic numbers disappoint elevated expectations. In that scenario, I expect the 5-10-year spread to widen.

    As for Europe, who knows what’s going on with their crazy monetary policy. Will they stick with negative rates forever? Or will Mario Draghi’s stepping down at the end of his term allow a German to be put at the helm of the ECB and raise short rates back to zero?

    I don’t know, but a hawkish ECB will most likely cause the same sort of flattening the U.S. has experienced over the past couple of years. When examining the age of the two countries’ economic cycles, Europe is a few years behind the U.S., so a flattening German curve very well might be the right call.

    Yet I am not sure if it is worth the hassle playing the yield curve differentials. The US steepener is a great risk-reward trade and it might make more sense to separate the two trades. Owning the U.S. 5-10-year steepener and then shorting the U.S./German 10-year spread might be a better way to organize the trade.

    After all, the spread between U.S. and German 10-year bonds hasn’t been this wide since the fall of the Berlin wall.

    Maybe this Shooter McGavin of a bond trader is being too cute for his/her own good. After all, never forget that Shooter blew a 4 stroke lead on the back nine.

    • yraharris Says:

      Peter–just a fantastic post and it arrived after a very great trader I know -emailed that very trade and wondered why the person went through all that effort when just sell the EURO–but your analysis is very good and the European curves are perplexing because of the current ECB action should be providing support to the longer end.One question posed to Draghi asked why the ECB did not embark on a plan similar to BOJ which targeted the ten year note–in typical Draghi fashion he danced it.The European situation is different from what the FED faces—the ECB is trying to create a EURO bond surreptiously by building a massive balance sheet guaranteed by the ECB and thus the EU—the yield curve in the U.S. appears flatter because of the massive intervention by the FED.Where it ends we don’t know but the fall off in the dynamic hedging of the market has certainly provided an impetus to flatten

      • David Richards (@djwrichards) Says:

        Yra, either I misunderstand or else I think you made a typo: the FX equivalent of Shooter’s trade is to BUY the EUR/USD, not sell it. Shooter’s trade profits if the US 5-10 curve steepens more than the German 5-10 curve (or flattens less). I think that’s bullish EUR and bearish USD.

        Instead, flattening of the US curve (typically caused by Fed hiking and/or falling expectations for long-term inflation) and steepening of the Euro curve (rate cutting and/or rising long-term inflation expectations) is bullish USD and bearish EUR, I think. Also to understand this, compare for example a currency hedged versus a currency-unhedged investment in US and German bonds for Japanese investors. Currency-hedged investments in US bonds will take away any yield advantage of investing outside Japan (because the Japanese must pay the carry to hedge against USD thus negating the yield pickup) whereas a currency-hedged investment in Bunds still offers a significant yield pickup versus JGBs. All else being equal, the fact that foreign investment in US bonds are more likely to be currency unhedged than for Eurozone bonds is bearish for EUR/USD.

      • yraharris Says:

        David–your first paragraph is correct but it is a long time line especially in light of Draghi’s performance last Thursday but if both of these events unfolded the Dollar would weaken but in the near term the rise in short yields is putting a bid to the dollar especially because there are monster short dollar positions in the market—the flattening of the curve has historically been bullish a currency and if my sense is correct there is a six to eight month period of possible lag—but we are certainly seeing this now .There were a great deal of unhedged positons on the dollar because there was enough enough vig to pay for the hedge and so it is now taking place as ratesin the U.S. rise causing pain to short dollar positions.The Japanese situation defies all analysis until the whole edifice comes under attack but the BOJ’S desire to buy the long end of the curve to hold ten year rates at zero is madness and either the BOJ exercises total forebearance on the debt or we will experience a monetary effect of historical proportions

  4. Mike Temple Says:

    Front end interest rate differentials make it tough to be short USD right now.

    However, I am not convinced that Powell can continue to tighten without upsetting the Apple cart.

    Presently, you can earn 2.23% on a one year T-bill.

    I think this is going to prove to be a challenge for stocks, especially if Powell raises and 1-year rates climb to 2.50% or higher.

    I think POTUS will scream loudly about wrongfooted rate hikes when stocks begin to succumb to interest rate concerns.

    Already, we know that levered companies are facing escalating interest bills due to their Libor debts.

    I don’t see how Fed can continue to push rates higher without undermining stock market in due course. Flattish yield curves are indicative of an economy operating well below max output.

Leave a Reply

%d bloggers like this: