Will inflation ‘catch down’ to the new economic reality?
July 4, 2022 – Weekly comment
Fierce decline in US rates in the past week, punctuated by a drop of nearly 11 bps in the five-year yield on Friday alone, to 2.894%. On the week the 2yr declined 21.4 bps to 2.84%, fives 28 bps, and tens 22.5 bps to 2.90%.
The rally in red Eurodollars was astonishing. EDH’24 and EDM’24 both fell 47.5 bps in yield on the week, to settle at 9720 and 9729. To give a sense of changes in the curve, here are weekly changes on December contracts:
EDZ2 9631.5 +05.0
EDZ3 9707.5 +45.0
EDZ4 9732.5 +43.0
EDZ5 9718.0 +28.0
EDZ6 9699.0 +19.0
So, nearly ½ percent of forward tightening was erased from next year. EDZ2 is the lowest contract on the curve at 9631.5 or 3.685% as the expectation of near-term hikes continues in conjunction with the Fed’s inflation fighting campaign. However, the market perceives great cost in terms of future economic activity, as EDZ2/EDZ3 plunged 40 bps on the week to a new low of -76 bps (the lowest one-year calendar on the strip). The Fed’s goal of crushing inflation expectations appears to be working, as the ten-yr breakeven between the treasury and tip fell to 235 bps this week, having been as high as 300 bps in late April.
It’s clear even from the brief table above that there was a mad scramble to exit curve flattening trades. For example, the red/gold Eurodollar pack spread jumped over 25 on the week, from -11.5 to +14.375. The table shows red Dec (EDZ3) vs gold Dec (EDZ6) having gained 26 to settle at 8.5. The constant maturity red/gold pack spread was as low as -87 on April 1.
The questions now become: How hard of a landing is in store? How long before the Fed officially pivots back toward the easing bias apparent in markets? Will equities and other risk-assets enthusiastically embrace the pivot, or will the reality of declining earnings be the dominant theme?
The data last week clearly points to a receding economy. Pending Home Sales yoy -13.6%. Mfg PMI 53.0 from 56.1 last, with the Employment component falling further to 47.3 and New Orders slipping below 50 (to 49.2) for the first time since covid. Q1 GDP final -1.6% and the Atlanta Fed’s GDPNow was last released on Friday at -2.1% for Q2, having been estimated at +2.1% as recently as early May. There was a sliver of progress on the inflation front, as Core PCE prices yoy printed 4.7% from 4.9%.
The good news is that a lot of commodity prices have deflated recently, from Corn to Copper to Cotton. HGU2 (Sept Copper) was 4.75 in late April and is now 3.57. CZ2 (Dec Corn) was 761 in mid-May, now 607. CTZ2 (Dec Cotton) was 130 in mid-May and is now 97.50. The bad news is that even though these commodities signal some relief on inflation input prices, the volatility also raises odds of economic dislocations. The most important commodity, Crude, has had a pullback as well, in response to the administration depleting the Strategic Reserves, but it’s now rebounding. CLQ2 (Aug WTI) was 120 in early June, fell back to 102, but is currently about halfway back, over 110. Keeping with the theme of C’s, we might as well give a shout-out to crypto, with yet another “crypto lender” Vauld, announcing the suspension of customer withdrawals. From the company’s statement: “…we have made the difficult decision to suspend all withdrawals, trading and deposits…” helpfully adding, “…arrangements will be made for customer deposits as may be necessary for certain customers to meet margin calls in connection with collateralised loans.” In other words, we’ve accentuated the pressure on your collateral by making the unavoidable decision to close, but we’d still like you to adhere to our margin agreements since your collateral no longer has the value to support your loan. It could be a South Park episode.
When does a run on a lender snowball into a systemic problem? It’s when one lender after another comes to the jarring realization that collateral is quickly losing the value to support loans. How can collateral adjust lower so quickly? Because it was artificially pumped up by low funding rates. How do we know it can’t possibly turn into a systemic run? Because the Fed has stress tests and all the banks passed them. THAT’S HOW. I know I feel better.
Thank goodness we have political leaders to address the problems. Here’s Illinois Governor JB Pritzker, who announced the magnanimous gesture of suspending the scheduled increase in the Illinois gas tax through election day. Gas stations are required to post signs at the pump informing consumers of this suspension. What the signs DON’T say is that it’s a savings of $0.02/gallon. My last fill up was $5.65 instead of $5.67. I saved 20 cents. The net effect is about the same as this guy switching to Diet Coke.
This week we have JOLTS and non-Mfg ISM on Wednesday, followed by the FOMC minutes. The employment report is released on Friday. Auctions of 3s, 10s and 30s next week, beginning July 11.
| 6/24/2022 | 7/1/2022 | chg | ||
| UST 2Y | 305.5 | 284.1 | -21.4 | |
| UST 5Y | 317.5 | 289.4 | -28.1 | |
| UST 10Y | 312.4 | 289.9 | -22.5 | |
| UST 30Y | 325.8 | 312.7 | -13.1 | |
| GERM 2Y | 81.3 | 51.5 | -29.8 | |
| GERM 10Y | 144.2 | 123.2 | -21.0 | |
| JPN 30Y | 123.0 | 122.6 | -0.4 | |
| CHINA 10Y | 284.9 | 282.9 | -2.0 | |
| EURO$ U2/U3 | 24.5 | -13.5 | -38.0 | |
| EURO$ U3/U4 | -36.5 | -42.5 | -6.0 | |
| EURO$ U4/U5 | -5.0 | 8.5 | 13.5 | |
| EUR | 105.58 | 104.30 | -1.28 | |
| CRUDE (active) | 107.62 | 108.43 | 0.81 | |
| SPX | 3911.74 | 3825.33 | -86.41 | -2.2% |
| VIX | 27.23 | 26.70 | -0.53 | |
