World Futures & Options Report
Today’s themes –U.S. Dollar, June Eurodollar futures, VIX index, 2-10 year curve, Hang Seng index, March Japanese yen, U.S. equity options movers – Dell Corp.
U.S. dollar
Seemingly out of nowhere, the greenback has hit skid row. After several months of showing promise, the dollar today has tumbled against 15 of the 16 most actively traded currencies. The euro has strengthened to a new all-time high reaching $1.5144, and currently shows no signs of backing off. Less than three weeks ago, the dollar had gained sufficient momentum to rally as hard as $1.4440 vs. the single European unit. This begs the question of what suddenly changed.
For the moment, two things are certain. First, there have been and there are no current signs of a respite for the housing market. It toppled the economy and for now has its knees firmly in the small of its back. Second, broadly speaking, the economy at large is not showing any signs of response to the drastic policy response from the Federal Reserve Bank. Earlier, that response was widely credited as a plausible reason for why the dollar might reverse course with the economy perceptibly back on a growth track.
June Eurodollars
Today’s media widely credits the dollar’s loss of value to the perception that the Fed will cut rates again. That’s a strange view, given that when the dollar reached its 2008 peak versus the euro, the June Eurodollar future was actually implying slightly lower rates that it does today. Nor can it be said that the interest rate market is looking for deeper cuts later in the year. The difference between the June and September contracts is still only around 15 basis points wide and indicates no fresh reductions in the fed funds rate as a result. The chart of June 2008 Eurodollars shows that policy watchers expect a further half percent reduction from the current 3% fed funds rate.
Chart: InteractiveBrokers
Two-year/10-year curve
It should come as no surprise to anyone that, with business and consumer confidence low, the Fed is set to ease rates. The problem the market has with this picture now is that inflation at both the consumer and producer levels remains elevated. After last week’s revelation through the release of the January Federal Open Market Committee (FOMC) minutes that it ought to be prepared to swiftly take away the punch bowl, the Fed has unwittingly engineered a sharp steepening of the yield curve. Regardless of whether producer and consumer price pressures are sticky or just slow to depart the scene, the market is now more concerned that the U.S. economy has an inflation problem going forward.
The spread between the yield on the two-year and 10-year notes is reflecting this headache and has rapidly widened to 185 basis points. This leaves the Fed treading on eggshells as it cuts rates going forward. It now has an additional problem of ensuring that liquidity reaches the parts of the economy that most need it. However, all is not lost since the same pattern emerged throughout the post 9/11 easing cycle. In similar fashion, the more the Fed leaned on the front end, the more the market pushed back at the longer end, creating a steep curve. The government response was to restrict supply by taking away the 30-year bond. The impact was immediate and irreversible as a strong message was delivered that “policy response will work.”
However, it may be some time before the Fed or the government does respond to the steeper yield curve. First, it’s early to be looking for a revival in the housing market, where easier policy should show up. Second, the curve could steepen a whole lot further first. During the last easing cycle and before the government pulled the 30-year bond off the market, the two-year/10-year spread surged to as wide as 285 basis points. In other words, the curve could steepen another 1% from here before the pattern has run its course.
While the dollar is weak, it’s weak against the euro and the Australian dollar. The same can’t be said about its performance against the pound or the Canadian dollar. But what we are also watching is an unusual rise in both carry trade victims: the Swiss franc and the Japanese yen.
Volatility
This does strike us as a little unusual, given the fact that stock markets are sensing that there might not be another shoe to drop after the recent monoline insurer plan gained credence. Perhaps it’s a little early to argue for a restoration of confidence worldwide large enough to create the next great bull market for equities, but we do note that investors are less prepared to pay higher insurance premiums through the option market. The following chart shows how the VIX has recently run rampant compared to its closing 2007 value.
Chart: InteractiveBrokers
Earlier this week the CBOE VIX index traded at its lowest level in 2008. Lately we had noticed that despite sharp intra-day index declines, the major equity averages were well off recent low points established in early February. It seems that this pattern has manifested itself in a weaker implied volatility reading. When the VIX recently traded at around 30, traders feared a further 8.6% slump in the S&P index over the coming month. Today’s reading at around 22 indicates reduced fears of a fall to the magnitude of 6.3% over the next 30 days. Today the S&P 500 index came within just six points of a monthly high, which is pretty impressive, given the fears embedded within the value of the dollar.
Hang Seng Index
With money flow finding its way back into equities, that speaks volumes about risk appetite and prospects for the carry trade. While the ascent of the S&P 500 index has been relatively gentle, the same can’t be said of the possible break-up of the Hang Seng index from a symmetrical triangle pattern.
Chart: InteractiveBrokers
Granted, that index is not at its highest point for the month of February just yet, but with just two trading days left to go it might be no surprise to see a strong close for global equities in February.
March Japanese yen
What strikes us as odd is that if this point in time does mark a resumption of risk appetite, then why the strength in carry-trade candidates? In the chart, you can see a break upward in the value of the March yen contract today. The question is whether this is a false break of the trendline in sympathy with a weakening of the dollar, or whether the equity market will ultimately determine the fortune of the unit. Remember, when equity markets are underpinned, it’s “safer” for investors to sell the low-yielders and invest the proceeds in stocks looking for capital appreciation from the long currency, a positive cost of carry and appreciation from investments where the cash is recycled.
Chart: InteractiveBrokers
U.S. equity options movers – Dell Corp. (DELL)
To close trading at the end of last week option traders in Dell bet heavily on disappointing earnings ahead of the official release tomorrow. That positioning on the computer manufacturer came despite a glowing report from Hewlett Packard last week. That alone might have prompted a more buoyant tone for Dell, but that certainly was not the case.
In the event traders scooped up a huge amount of March puts at the 19.0 strike seemingly for fear of an earnings miss. Open interest at this strike surged from 18,626 mid-month to 65,918 contracts as of Tuesday. Investors forced premiums higher on Friday to as high as $0.80 as the share price reached a penny above the strike. That decline marks a 38% slide in Dell’s fortune since the market peak in October.
Although the option open interest on Dell remains in favor of the bulls on the stock, the elevated put-side volume did give an air of doom for the company. However, the broad market recovery since the last hour of trading on Friday coupled with one analyst’s note this week that Dell maybe gaining market share has sent its share price to a one-month peak. Apparent evidence from Best Buy and Staples indicates this. Put buyers late last week may be kicking themselves for being so bold. However, we’ll have to wait and see after hours on Thursday to see if their fears will yet play out to launch an assault on Dell’s 52-week low of $18.87.
Chart: InteractiveBrokers
Andrew Wilkinson and Rebecca Engmann Darst
ibanalyst@interactivebrokers.com
Note: The material presented in this commentary is provided for informational purposes only and is based upon information that is considered reliable. However, neither Interactive Brokers LLC nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Neither IB nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.
