FOMC projections
September 19, 2021 -Weekly Comment
A Sunday headline on WSJ.com: Junk-Debt Sales Soar Toward Record Year.
The $3 trillion market for low-rated companies’ debt is having its best year ever, powered by a rebounding economy and investors’ demand for any extra yield.
Real yields on both US and European junk are negative. The obvious incentive is to borrow as much as possible. And they are. It’s obvious to the Fed as members convene for the FOMC. Of course, the reason for negative real yields is because inflation has surged. It’s somewhat interesting to visit the websites of the regional banks and look at their measures of inflation, which I summarize below. First though, a few words on the dots.
In March of this year, 14 participants expected rates to stay 0-0.25 through 2022. Three expected 1 hike and one expected 2 hikes. Median PCE inflation and Core projections were both 2.0%. For the year 2023, eleven members still expected 0-0.25%, and seven members expected at least one hike, with two members looking for a target of 1.00-1.25%. That’s with a median inflation expectation of 2.1%.
At the June Summary of Projections, in 2022, the number of members expecting a hike went from 4 to 7, with two members now at 0.5-0.625%. For 2023, the number expecting no hike went from eleven down to five, with thirteen looking for 1 to 6 hikes of 25 bps. The 2023 inflation expectation was only moved 1/10th higher to 2.2% for 2023, with Core unch’d at 2.1%. A BBG article (Stymied Bond Bears…) notes it will only take three members to raise their unchanged dots for 2022 for a full hike to be the median for next year. That would align perfectly with the Eurodollar curve: EDZ’21/EDZ’22 is 26 bps, unchanged from last week. For 2023, three members expected 2 hikes, three expected 3, three were at 4 and two were at 6. It’s fair to say that the dispersion spooked the market and resulted in a much flatter curve, with 5/30 imploding from 140 to 113.5 in a few days. Going into this week’s FOMC, 5/30 is even lower, at 104. In terms of the 2023 dots, if anything the market is a little bit BEHIND the Fed. EDZ’22/EDZ’23 is 63.5. After adjusting for the libor transition, which occurs at the end of June’23, that’s about 2 hikes. The average of the 18 dots in June for 2023 was 69 bps, slightly over two hikes. At this SEP, the dots will surely move higher again, because inflation estimates will have to be acknowledged higher.
Let’s take a look at some of the regional Fed inflation data:
From NY Fed: Both median year-ahead inflation expectations and the three-year horizon increased by 0.3 in August, to 5.2% and 4%, both series highs. (Sept 13)
Atlanta Fed: Year-ahead Business Inflation Expectations 3.1% [new high]
Sticky Prices +2.6%. “The flexible cut of the CPI-a weighted basket of items that change price relatively frequently- increased 6.3% (annualized) in August and is up 13.7% yoy.”
SanFran Fed: Cyclical Inflation 3.55%. Acyclical inflation 3.71% [this latter series avg’d about 1% from 2014 to 2020]
Cleveland has an interesting Inflation NowCasting chart for Q3 2021: CPI 6.56%, Core 5.47%, PCE 4.87% and Core PCE 4.12%.
Richmond Fed Mfg Survey (Aug 24). Prices paid 11.05 [was 4.91 in Feb]. Prices rec’d 9.25 [was 2.90 in Feb]
Perhaps the most useful (though somewhat stifled) survey comes from the Philly Fed which prints the Aruoba Term Structure of Inflation Expectations from three to 120 months ahead. The August release shows near term expectations at 2.3%, and out to ten years, 2.26%. “The ATSIX is created by using a factor model to optimally combine major surveys – the Survey of Professional Forecasters published by the Philly Fed and the Blue Chip Economic Indicators and Financial Forecasts published by Wolters Kluwer Law & Business – using a methodology in Aruoba (2016).”
The other regional banks don’t offer much different. The point is that Fed Presidents should probably rely heavily on the staffs in their own banks for inflation projections. I didn’t see anything on regional websites that can justify a “longer run” SEP inflation estimate of 2.0% or a 2023 print of less than 2.3%.
Therefore, dots and economic projections must both be set higher. Which of course, argues for getting on with the taper. Even with Friday’s pullback, BBG Commodity Index is up 37% annualized in 2021. The spot Base Metals index is up 42% on an annualized basis. The BBG Energy sub-index Is up 100% annualized. It all makes the annualized 26% gain for SPX look tame.
While the tentative first hike of the last cycle was in 2015, there was a long pause before the more concerted two-year campaign from 2017 to the end of 2018. 5/30 began 2017 right around current levels at 110, but had moved to a low of 21.5 by the middle of 2018. Over this period, the thirty year yield ranged from 2.70% to 3.25%, eventually topping at 3.45%. It’s now 1.91%. Over that period inflation (CPI) ranged from 1.65% to 2.945%. It’s now 5.3%. In 2017/18 the bond yield was always greater than CPI.
I think the Fed will announce the onset of tapering at this meeting, to begin in November with an implementation note. There has been ample preparation. Even though the market believes hiking will quickly follow the taper, the Eurodollar curve is not aggressively priced that way. In fact while the red pack to green pack settled 58.25 on Friday, around 2 hikes, the green to blue pack settled at only 32.375. (Red pack is EDZ’22 thru EDU’23, Green pack EDZ’23 thru EDU’24, Blue pack EDZ’24 thru EDU’25).
My bias is for all rates to adjust higher. I believe the rate market will take taper in stride; that equities will be more likely to reflect the marginal withdrawal of liquidity. I think 5/30 will flatten a bit further, holding in the low 90’s, but that steepening will occur on the dollar curve from EDU’23 back. That is, green/blue pack sub-33 is too low and blue/gold at 20 is also too low. Powell will go to great lengths to counter the idea of hikes immediately following the end of taper, regardless of the dots. The current shape of the curve indicates he has been successful so far in that effort. But he may ultimately be much less successful on the ‘inflation is transitory’ mantra.
The FOMC announcement and press conference is Wednesday. The Fed’s quarterly Z.1 report comes out Friday for Q2, which is a nice punctuation point to indicate how much Household Net Worth (especially at the top) has swelled as a result of Fed and fiscal largesse. In Q2 SPX up 8% or 36% annualized, while the White House notes, “…over the last 12 months, the Case-Shiller US Nat’l Home Price index has risen 18.6%, the strongest year-long growth in the history of the series.”
OTHER MARKET THOUGHTS/ TRADES
There’s some pretty chunky FV put positions, as evidenced by Friday’s purchase of 50k FVX1 123.0p for 17/64’s. This is a 40 delta put; settled 16.5 vs 123-09. Works out to about $1m DV01. Breakeven is 122-23+ which is about 10 bps higher; current 5y cash is 86.5 bps.
October treasury options expire Friday. In TY, the peak call positions are 133.5c and 134c with 76.6k and 85.6k. Open interest In both fell heavily on Friday as the long 133.5/134c spread that had originally been bought for 10 was partially liquidated; call spread settled 3. On the put side peak open interest is TYV 132.5p at 83.8k and TYV 132p at 97k. Settles 13 and 5. Ought to be some gravitational pull to the 132.5 strike.
I know nothing of NatGas production, demand, or storage. However, the March’22/April’22 NatGas calendar spread is quite interesting. A chart is below. Jan/Feb’22 is 0.084, Feb/Mar’22 is 0.342. Then Mar/Apr’22 is 1.199 ! with Apr/May’22 back to 0.127. Dec’21, Jan’22 and Feb’22 contracts are all over 5.25 while April falls back to 3.703. This has been a huge rally in NatGas. Hoping it’s not a cold winter because the cost of home heating is going to really hammer the lower end of the household sector.
| 9/10/2021 | 9/17/2021 | chg | ||
| UST 2Y | 21.5 | 22.4 | 0.9 | |
| UST 5Y | 81.4 | 86.5 | 5.1 | |
| UST 10Y | 133.9 | 136.8 | 2.9 | |
| UST 30Y | 193.2 | 190.8 | -2.4 | |
| GERM 2Y | -70.4 | -69.5 | 0.9 | |
| GERM 10Y | -33.0 | -28.0 | 5.0 | |
| JPN 30Y | 65.6 | 65.2 | -0.4 | |
| CHINA 10Y | 287.1 | 287.9 | 0.8 | |
| EURO$ Z1/Z2 | 26.0 | 26.0 | 0.0 | |
| EURO$ Z2/Z3 | 57.5 | 63.5 | 6.0 | |
| EURO$ Z3/Z4 | 38.5 | 41.0 | 2.5 | |
| EUR | 118.11 | 117.29 | -0.82 | |
| CRUDE (active) | 69.47 | 71.82 | 2.35 | |
| SPX | 4458.58 | 4432.99 | -25.59 | -0.6% |
| VIX | 20.95 | 20.81 | -0.14 | |
