The S&P 500. Bitcoin. The VIX Index. Most investors are aware of these markets and indicators that they are stretching to record levels. It is an environment ripe with optimism (some say speculation), impacting all asset classes in all geographies. Equities and bitcoin dominate the headlines, but there are other developments in the financial markets worthy of discussion. Here are a few examples of other lesser-known markets reaching new highs or lows:
Crude Oil & Futures Contango
An extension of production cuts from OPEC and non-OPEC countries, helped by political tension in Saudi Arabia, have pushed spot crude oil prices up more than 35% since the middle of June. Crude for forward delivery has risen half as much. This change in the shape of the oil futures curve and the impact it is having for hedgers and speculators is an unusual development. Over the last six months, the futures curve has moved from upward sloping (deferred contracts trading higher than near contracts) to inverted. U.S. producers have taken advantage of the higher oil price and pre-sold their production for future delivery, capping the rise in the deferred contracts. During the past summer, two-year forward contracts traded roughly $4 per barrel higher than the front contract. Today, it is the reverse. The deferred contract is trading $4 below the near contract.
The downward sloping futures curve also makes it less costly to buy and roll futures contracts. Speculators who buy futures contract no longer have to bear the massive roll-cost of holding a long oil position. The lack of negative carry in holding a long crude oil futures position should help sustain the price rally.
Interest Rate Volatility
Interest rate volatility is now trading at historical lows. Systematic sellers have pummeled short-dated volatility in search of alternative risk premia. Program selling of volatility in the equity market has been around for some time, but it is a relatively new phenomenon for the interest rate market. Quantitative easing and forward guidance from the major central banks have kept a lid on daily movements in both short and long-dated interest rates. Option buyers still can't make money, even at the depressed levels of implied volatility. The expectation that fluctuations in rates would increase as the Fed reversed policy has not materialized. What could be the catalyst to break the trend in 2018? Possibilities include an upward surprise in inflation, the change in leadership at the Fed, or a correction in risk assets.
Yield Curve Flattening
The flattening of the yield curve has picked up speed in the last six months. 2-year yields are responding to higher anticipated policy rates from the Fed while 10-year and 30-year yields are benefiting from benign inflation expectations, a repricing of the terminal Fed Funds rate, and pension fund flows from tax reform. The spread between 30-year and 10-year US Treasury rates has declined from 60 bp to 36 bp in the last three months. Historically, a flat yield curve has been a good indicator of a coming recession, so investors are paying particularly close attention to yield curve dynamics. Two things to note: First, there is a difference between a flattening yield curve and a yield curve that is flat. In other words, there is still a long way to go before 2-year rates rise above 10-year rates (it’s currently 52 bp steep). Second, even though an inverted yield curve has preceded each of the last seven recessions, it has done so with an average lag of one year. The bottom line is that it is too early to expect a recession based on the shape of the yield curve.
Citi Surprise Index
The Citi Surprise Index is an indicator published by Citibank to track economic strength. Rather than focus on the absolute level of the data, it measures the degree to which economic data exceeds or falls below expectations. It is a useful indicator to gauge economic momentum. If data surprises to the upside or downside, there is a chance that markets will react (a data release that comes in on consensus is not "news.") A positive number reflects a positive surprise trend and a negative number indicates a negative trend.
Citibank constructs these “Surprise” indices for individual countries as well as geographic regions. In the United States, the economic data has surprised to the upside since June, after coming in lower than expected in the first half of the year. It hit a new high this week. In a global expansion, one would think that countries would be moving in sync when it comes to meeting or falling short of economic expectations. Interestingly, the momentum of positive surprises in emerging markets has diverged from the United States in the last three months. This divergence could explain some of the recent out-performance of the U.S. equity market relative to broad emerging markets indices.
Investment Grade Credit Spreads
Credit spreads are correlated with equity prices, so it should not be a surprise to see investment grade spreads reach new lows as the stock market sets new highs. With the CDX IG index at 50 bp, credit default spreads are at their post-crisis low. The all-time low for the index is 32 bp, reached back in January of 2007. It’s important to note that the two time periods are not directly comparable. As I pointed out in a post a few weeks ago, the index today is more leveraged and has a worse average credit rating. In the case of credit, we may not have hit the all-time low in spreads yet, but we may be at the bottom when it comes to value.
