March 5. Finally, a meeting where something gets done!
A client once said, it would be nice in your missives if you spent less time talking about the environment we’re in and spent more time telling us what was going to happen. He was sort of joking. But like every joke, he sort of wasn’t. So… in this note I describe the current environment.
First, I would like to highly recommend a new book by Michael Lewis, The Undoing Project,* which highlights the psychological research of Danny Kahneman and Amos Tversky on decision making. I am not through the entire book, but its main thrust is that people, including highly trained professionals, wrongly estimate odds (by a lot) in arriving at decisions, through a variety of biases. There are many amusing, though quite serious nonetheless, examples, even doctors that are using the same diagnostic tools for evaluation and coming up with varying conclusions, occasionally even contradicting themselves, even though the key factors that determine a given disease were already identified and agreed upon. I will be returning to this book many times, but for now I will simply quote a passage. “He [Tversky] had listened to an American economist talk about how so-and-so was stupid and and so-and-so was a fool, then said “All your economic models are premised on people being smart and rational, and yet all the people you know are idiots.”
The reason I mention the book is because the topic is obviously of interest to the Fed. The other Fed speech on Friday was co-chair Stanley Fischer’s, on Fed decision making, rules vs committees.** It’s obvious that Fischer leans toward human intervention through committees; that is, after all, his life’s work. And like other professionals in the Undoing Project, he holds the concept that the array of information is so vast and complex that a simple model will fall short of thoughtful analysis. But in his last couple of speeches he is very clearly giving the matter serious thought.
Let me give an example of professional analysis. Towards the end of last year, there were numerous articles identifying the new Fed board as dovish leaning relative to the last, and what the implications of that change might mean. For example, having seen inflation already ticking up, one might be inclined to sell butterflies on the Eurodollar futures curve. This, for example, was my thought: that the Fed would be slow to respond to actual increases in inflation and therefore the back end of the curve would steepen relative to the front. In fact I had recommended doing just that, selling EDM7/EDM8 spread and buying the two year spread behind it, EDM8/EDM0 at a level of -13. Settled -8 on Friday and traded higher during the week; I would have been stopped out. Even though we THOUGHT the Fed would hew to the dovish line this year, members clearly began to signal a hike in March, through Kaplan and Brainard, and punctuated by Yellen on Friday. Brainard laid out the case quite clearly on Wednesday and even said, “Recent months have seen an increase in the upside risks to domestic demand.” Yellen essentially said that a hike in March is a done deal: “Indeed, at our meeting later this month, the Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.” She also spent a reasonable amount of time talking about the estimated decline in the neutral rate, suggesting that total rate hikes won’t be of great magnitude. She did however, repeat that “…a cumulative 3/4 percentage point increase in the target range for the federal funds rate would likely be appropriate over the course of this year”, and added “…partly because my colleagues and I expect the neutral real federal funds rate to rise somewhat over the longer run, we projected additional gradual rate hikes in 2018 and 2019.” Implicit in this analysis are several ideas. First, that the Fed will be successful in holding inflation at its 2% goal and second, that China or another part of the world won’t implode. (I mention China here rather than the Eurozone due to a recent NY Fed paper outlining looming issues in China).
In some ways, I think the Fed moved up the hike timetable simply due to the departure of Daniel Tarullo from the Fed’s Board after this meeting. There are already two unfilled vacancies, and Tarullo will be the third of seven. I recently read a note that said with only four members left on the board, even informal deliberations will be subject to FOIA requests, i.e. ALL conversations will be more or less public. Or maybe the Fed simply decided they could sneak a hike through now, while Donald is too preoccupied with Arnold to notice.
How are we left in the markets? First, January 2018 Fed Funds settled at 9868.5 on Thursday and 9870.5 on Friday. If we take the current Fed effective of 66 and shave off half bp for month-end weakness, that’s 65.5 (a price of 9934.5) vs 129.5 implied by the Jan contract, a difference of 64 bps. Complete certainty of three Fed hikes this year would, of course, have FFF8 at a rate of 140.5, a price of 9859.5. So the market hears Yellen, but because of being burned a couple of times already, won’t entirely trust the Fed forecast. This is also apparent in one-year Eurodollar spreads. For example, EDM17/EDM18 settled 57, up 11 on the week but still only projecting a bit over two hikes per year, and EDM18/M19 settled at 40.5, a marginal new high, up 6.5 on the week, but well under ½ pct.
Unemployment is released Friday, but now has little market moving value unless it’s a huge outlier. Not surprisingly, implied vol seeped out of the market by the end of the week. In the 2004 to 2006 hiking cycle the market was programmed to expect a hike at every meeting. Once into the pattern, vol was tame. In hindsight, while the curve flattened and other signs of dislocations were apparent in the last hiking cycle, it still took another year and a half for the damage to occur in the form of a crisis. It’s the boiling frog syndrome: at first you don’t notice the heat being increased…
Speaking of professional advice regarding decision making, here’s a link to a salient article. It sagely informs us that investment results will improve if we can sidestep crashes. Thanks.
“Alas, for investors looking for guidance on whether to sell now, the paper holds few clues. The reason is simple: nothing going on in the market today would’ve qualified for investigation under the authors’ base case for bubbles.” [In other words, sell now].
Besides the employment report, we also have auctions of three, tens and thirty year bonds this week. The FOMC meeting is March 15. On a personal note, whenever I think of committees and business meetings, I can’t help but think of the Barrons cartoon below, from many years ago.
