Bogus Tweet Risk

Most financial media is focused on “tweet risk” or “trade wars”. To me, these seem like water under the bridge. It’s in China’s interest politically to retaliate to trade sactions, but not in their interest to crash US markets. They hold a massive amount of US Treasurys, if they stop buying US bonds, rates will shoot through the roof and China loses. The following analysis attempts to succinctly summize the economic situation.

Tempered Expectations of Future Growth

We’ve crossed the 50 bps level in the 2 to 10 year US Treasury Spread, signaling lower expecations of future growth prospects, strengthening the late stage economic growth narrative.

US Dollar Slides

The DXY Index represents the US Dollar vs a basket of major currencies. Yields in the above chart are represented by the Generic 10-Year US Treasury yield. Higher yields depreciate a currency, as stated by Interest Rate Parity.

A weaker dollar allows foreign investors more buying power in US markets.

Resilience of US Goverment Capital Markets

The 10-Year Treasury rate now sits at around 2.75% following last week’s sale of a LOT of Treasurys. The market is handling this flood of supply well (nearly $300bil last week), as bonds have rallied in the face of rising interest rates. The US Treasury Department will auction off $48bil of 3-month T-bills and $42bil of 6-month T-bills this week.

Rates on the short end are slightly higher following a Fed funds rate hike in March, but longer term yields have fallen since last month signaling strong demand for US debt.

Higher Volatility but Lower Tail Risk

We’ve seen elevated levels of stock market volatility since the beginning of the year. However, since last month we’ve seen less tail risk, i.e. a flatter Volatility Skew.

Elevated levels of Volatility overall
Lower levels of Vol Skew

Tail Risk is the risk of a Black Swan event. This is measured by the relative demand of out of the money calls and puts. As the volatility smile flattens, the market is pricing in less tail risk, albeit at an elevated level of overall volatility.

Higher vol means more trading, which is good for financial services, as are higher rates. A trade war will be bad for industrials. I’ll be watching financials (XLF), and industrials (XLI).

Thanks for reading,

/tommander-in-chief

What I’m Reading: Lords of Finance: Bankers Who Broke the World

Sauce:

https://www.wsj.com/articles/treasury-to-sell-90-billion-in-debt-1522342484
https://www.wsj.com/articles/foreign-investors-are-bulking-up-on-u-s-treasury-bonds-once-again-1522693557

Disclaimer: The opinions above are my own and are for information purposes only. This post is not intended to be investment advice. Seek a duly licensed professional for investment advice.