Pivot or no pivot?
Credit markets review 10.10-16.10
Friday’s jobs report was yet another blow to the ambitions of the long crowd. Each economic release has been watched as closely as ever in the hope we get a sign of a pivot. But the pivot doesn’t come. One would have thought that by now we should have seen signs of a cool down in the US economy. It is widely argued that changes in interest rates need 9-12 months before they show the intended effect. We are obviously not there yet as just until Jun’22 we were at 1%. So if we need to wait at least 9 months to see an effect from the first .75bps hike, then we need to wait until the spring of ‘23. Until then we sell off on every major economic release. The big question which every trader and investors asks themselves is if the FED will indeed stop at around 4.5% and wait for more evidence on the effect of the hikes. That pivot is what everyone has been waiting for but still unclear if we will get it or not. There is pressure to shift the pivot higher, if one believes there will be one, as new economic data clearly shows the economy is still running strong. My personal sense tells me the FED will march toward 4.5%ish even if weaker data starts coming before the spring of ‘23 when we are projected to reach 4.5%. which will likely cause further rout in the markets when the FED would really not want to cause that. I have to admit I am also seeing some strong counter arguments. Energy prices, expressed in commodity prices, may rally from here, given the anxiety around OPEC and the United States. This will certainly put further pressure on the FED, especially if they get unlucky and see oil prices higher while economic data comes in stronger. That combination will deal a huge blow to the FED and they will likely shift the expected terminal rates higher. It will of course depend how high energy prices may go but I am thinking if we go above 5% terminal rates things will really look bad.
FIXED INCOME ETFs:
MUB looks relatively stronger, forming a higher low on the chart. That is certainly a change in scenery and an event to note.
HYG - It makes an impression that it is also relatively stronger compared to SPX. This shows on the chart by not being near to the lows.
I am intentionally showing relative strength on charts to get you prepared in case we see a short-term rally from here. In such cases you should always go for strength rather than weakness.
CURRENT TRADES:
MET-F vs MET 3.85 - 1x3 size. I have very little left of the position. I want to point out that this is currently a winner ONLY because I had skewed the ratio to be x2 more exposed to the short side. At a 1x1 notional exposure the trade would have been a loser.
Bought EUR sovereign paper early last week in the hopes of a rally. Charts were right at the bottom and thought the risk to reward is phenomenal if we get an even slightly worse unemployment number, heck even inline numbers would have worked. I got in REPHUN 4.25% 31s at 85.17 and BGARIA at 91.80 4.625% 34s. So far the trade is not going well but luckily I got hedges on Thursday evening just in case unemployment numbers are better than expected. Even with the hedges both trades are currently sitting at loss, but luckily a small loss compared to what could have been.
POTENTIAL TRADES:
LQD vs HYG - I think we are at a great level at the ratio chart, especially if you believe HYG had not taken a punch yet. This will happen if the market breaks lower, while rates stabilize. At some point I believe we start getting into the narrative that rates actually broke something and that the FED will pivot, very likely as soon as we start seeing lower than expected economic numbers hitting the board on a daily basis. It will eventually happen.
2. Buy slightly OTM TLT calls on Wednesday, before the close, with expiration 1-2 weeks away. Should we get lucky we sell further OTM calls if we get 2-3 point move in our favor. That way we will have significantly lower risk and can ride the trade without much anxiety. Furthermore, should we see a big downside day we simply get out of the calls at the close on Thursday, hopefully not risking the full premium. I have no idea what the CPI number will be on Thursday but from a risk to reward perspective I think we have a case for a sharp rally in bonds IF we see a lower than expected CPI number. The added benefit to this trade is the potential for further sell off to the downside caused by worse than expected earnings season. Such an event would certainly trigger further buying in long dated treasuries.
RISKS:
CPI numbers on Thursday. This will be the big one this week. I think it is about time we see a lower than expected number but to be honest I am not sure what the effect will be. I bet the initial reaction will be a squeeze higher in equity and credit markets but after a few days maybe people realize the FED is successful in its plan to slow down the economy and potentially get us into a recession, which will likely lead to further downside in equities but will serve as a huge bid to the long-end.
Start of earnings season. Blackrock on Thursday and several big banks on Friday.
#earnings for the week eps.sh/cal $JPM $PEP $TSM $DAL $MS $C $UNH $BLK $WFC $DPZ $AZZ $WBA $USB $CMC $FAST $PNC $PGR $WIT $FRC $THTX $DCT $ETWO $APLD $VLNS $INFY
An equity markets sell off will lead to credit spreads expansion in fixed income instruments. Bids will be wider and mostly non existent. Long-end rates will start going down sharply. I have been thinking this kind of environment was to be expected on multiple occasions this year but we have not yet seen a stress event in credit markets despite equity indices being 25% - 30% from their respective highs. We have witnessed only repricing of credit instruments to correspond to prevailing interest rates and nothing more. Stress scenarios like the Covid crash in 2020 or the GFC in 2008 are a different game to what has been happening so far. Basis may be high and close to 2020 levels but stress is no where near, so if we see any stress I am convinced basis will go higher, together with credit spreads.
CONCLUSION:
We are still in the narrative of bad news for bonds is bad news for equities. As soon as the FED’s policy starts working and we begin seeing lower than expected economic numbers we will change that narrative and move into bad news for equities is good for bonds, as we will move from higher rates for longer to pivot or even cuts, depending on how bad numbers are. However, one should clearly remember that we will still remain in a volatile environment where we trade from one economic release to another, just like we are now. Volatility and hence short-term trading will be with us for longer than most people anticipate.
