Before March 10, 2023, these kinds of moves had been exceptionally rare. In eurodollar futures and now SOFR futures (term), daily swings of greater than 20 bps were reserved for the most momentous occasions. Contract prices skyrocketed, for example, when news of Lehman Brothers hit. They doubled even that the Monday following SVB.
Yesterday was different. Though contract prices shifted more than 20 bps, this time it was in the other direction. Starting around 7:30 am EDT, the crucial June 2024 was up to around 96.13. Over the next nineteen minutes, a massive wave of selling (hedging) took the price down to 95.92. It was as intense and acute as those days in March had been.
Similar moves are happening in the Treasury market, too. The US 2-year note has seen its yield surge from 3.99% on May 15 to 4.50% as of Thursday’s close, with the rate jumping 19 bps yesterday alone.
If desperate and insane buying of USTs and SOFR futures represented hedging against imminent banking crisis disaster, what is the opposite selling?
You’d want to buy SOFR futures if you owned a lot of risky assets which were more likely to get hit if this year’s bank failures lead to widespread fallout in the markets and the real economy. Up to 2008, you could hedge in single-name credit default swaps against many financial and non-financial positions well enough.
Those are largely gone, a byproduct of dealers waking up to what they’d been doing. So, instead of CDS opt for systemic rate hedges like what’s offered in SOFR (before them eurodollar) futures. A complete economic wipeout accompanied by major financial volatility would mean lower rates, making forward rate derivatives at current “low” prices a worthwhile hedge.
Those become much more valuable if or when interest rates end up much lower.
So, massive selling of SOFR futures implies hedging for rates feared to…surge. Is inflation about to get real?
If that is the case, it would be the first time these markets believed and acted as such. Even when the CPI (or PCE Deflator) was rising at its fastest pace in 2022 there was nothing like this. In Treasuries like 3-month SOFR futures, market participants were dragged to lower prices on the impetus of the Federal Reserve’s rate hikes alone, never once inflation expectations.
There doesn’t seem to be much danger from rate hikes, either. While another 25-bps rise isn’t out of the question, the recent FOMC Minutes published Wednesday show a very much divided group in which the apparent majority is likely to opt for at least a pause at the next meeting several weeks from now. According to the text:
“Participants judged that risks to the outlook for economic activity were weighted to the downside, although a few noted the risks were two sided. In discussing sources of downside risk to economic activity, participants referenced the possibility that the cumulative tightening of monetary policy could affect economic activity more than expected, and that further strains in the banking sector could prove more substantial than anticipated.”
Only “a few noted” inflation risks. Among the “participants judged” group is Atlanta Fed President Raphael Bostic who this week said, “Right now, absent a big change, I think I will be comfortable saying let’s just look and see how things play out.” Officials always say they’re going to be data dependent, and there’s another payroll report then CPI data (and other high frequency macro statistics) coming out between now and the next decision for them to depend a lot upon.
Perhaps the marketplace has seen something in the real economy which will change Bostic’s mind? Maybe SOFR hedges are being put on from those who are observing a real burst of hiring and wages in the real economy, maybe a related large swing in consumer prices which together with labor data might sway these majority policymakers to give up on this pause, skate past a 25-bps hike and go all the way to fifty or more.
But if that was the case, how would anyone explain commodities? Sensitive to demand as well as liquidity (actual, as opposed to what everyone talks about with the Fed’s bank reserves), start with oil prices which continue to strain lower. This week Saudi Arabia’s Oil Minister Prince Abdulaziz bin Salman stooped to delivering a veiled threat to cut more production.
In fact, though global oil supply remains tight and suppressed while inventories on land and sitting in tankers around the oceans are relatively low, the WTI futures curve is once again back into contango up at its front (a negative sign).
It’s not just crude oil, though, as many economically-sensitive commodities are suddenly drowning in deflationary trends. The biggest one is copper which just set a new multi-month low after China’s hugely-hyped reopening has thoroughly failed in every possible way. It has been joined by steel prices in Shanghai going even comparatively lower (right on the edge of a multi multi-year low).
Reopening was glorified as the solution to a great many problems in and outside of China, starting right from the top was its beleaguered property sector. It’s not even June and conditions there are worse than they had been to start this year even with the economy completely reopened in between.
At mid-month, KWG Group Holdings defaulted on one of its offshore dollar-bond obligations, its eighth event in recent months despite having received onshore support from China Bond Insurance Company (one of the country’s big state-owned financial instruments). It is a complicated story, as they always are with offshore China relationships, yet emblematic of a growing problem from inside the Chinese borders spilling over into the wider eurodollar world.
Without the financial growth from cheap money, or any money, uncertainties about China’s real economy mean real estate woes go much deeper than just home or office building prices. No one is building, not even the government.
That deflationary trend has already extended further into the general goods sector, too. Flagging demand globally has left Chinese factories with major overcapacity. As a result, producer prices have accelerated to the downside while factory gate prices sink even faster. Finding it difficult to sell what’s being made, producers are buying a lot less materials to make anything.
Thus, deflation across commodities only begins with copper and crude.
Such swift, thorough, and predictable failure of China Reopening has profound implications, maybe more so outside the country than inside. For anyone upstream of Chinese production, including Prince Abdulaziz, falling commodity prices amplify the pain of lower demand for raw materials.
And those downstream on the supply chain, this deflation is a recognition of global recession already striking the advanced economies including here in the US where retrenching consumers and businesses aren’t going to be massively hiring and binging on product buying.
This makes it beyond unlikely hedging for higher rates in SOFR futures and the selloff in UST bonds is the entire marketplace suddenly abandoning its long-held suspicions about global deflation and recession at exactly the moment these are being realized.
We also have to consider other similar markets such as the UST peer over in Germany. Bunds and bobls have had their rates rise, too, though nowhere near as much or as messy as these here in US$ terms. Comparing rates at the same maturities, Treasury’s German counterparts have added less than half the yield increase since May 15.
Even today, as these huge selloffs in SOFR and Treasuries were developing in the morning, there was barely a note in bunds or EurIBOR futures; the June 2024 3-month EurIBOR contract was down 8.5 bps on the day, nowhere near the -26.5 bps for the same maturity in 3-month SOFR.
In fact, I would argue that these extreme moves in US$ markets are the reason for moderately rising rates and falling EurIBOR futures prices to begin with, a knock-on global effect.
By process of elimination, we’re left with only one domestic explanation and that’s the obvious one meaning the debt ceiling. Markets don’t know what to make of the current impasse and aren’t waiting around to see how or if it gets resolved. Should a default happen, however low the probability, it’s not hard to imagine Treasury rates jumping without any assistance from the pause-minded FOMC.
To hedge against that, especially if you trade for a regional bank, panic-selling SOFR futures would be one way. You would also sell/short cash USTs, though I wouldn’t advise this for beleaguered depositories still facing depositor runs who’ve been told underwater Treasuries are the reason banks are in trouble (they aren’t).
What does this mean if or really when the debt matter does get ironed out? Markets that were temporarily preoccupied by rising yields and falling prices for decidedly non-economic reasons will immediately and feverishly refocus on these global economics. Quite naturally, prices would reverse and fast especially given the worsening, more deflationary situation being displayed right now across copper, crude, and, yes, rising dollar (see: CNY).
That last one is another clue: the dollar going up in exchange value particularly against Asian currencies as a matter of more serious deflationary conditions outside the US even if inside the country debt ceiling matters take up more space in Treasuries or SOFR futures.
Though some of the usual suspects have warned that a political deal will actually be bad for these markets, something about falling bank reserves as Treasury replenishes its TGA account, you only need to look around at the “liquidity” that has since piled up in safety alternatives like US$ repo.
GC repo volumes have absolutely exploded going back to January, predating SVB showing how deposits had indeed migrated from that class of banks to MMFs and other larger banks only to stop recirculating, seeking instead the safest, most liquid instruments. Along with the $2.2 trillion available in RRP (sitting there for the same reasons), lots will be eager enough to pile back in on Treasuries starting with bills once the necessary politics get done.
Either way, what’s happening now is only making everything worse. So much violent volatility first in the one direction and now the other, first for a banking crisis then non-economic nonsense, it’s all beyond unhelpful. Serious costs (to balance sheet capacities) are being incurred due to so much unnecessary unpredictability.
Gratuitous agitation with real consequences. And with September’s bottleneck looming large next on the global monetary calendar, there's a real ceiling on money, finance, and economy that has nothing to do with the US government.
