It will never be exactly right
November 13, 2022
Wild week. CPI slightly lower than expected. Elections; Republicans regain the House. FTX/crypto implosion. Powerful equity rebound as yields plunged. SPX up 5.9% on the week and the ten year yield plunged over 30 bps to 3.83% by Thursday’s close.
In this note I am just focusing on the front end with respect to the forward path of Fed policy.
Here’s a clip from Powell’s press conference on November 2:
Again, if we over tighten, and we don’t want to, we want to get this exactly right, but if we over tighten, then we have the ability with our tools, which are powerful, to, as we showed at the beginning of the pandemic episode, we can support economic activity strongly if that happens, if that’s necessary. On the other hand, if you make the mistake in the other direction, and you let this drag on, then it’s a year or two down the road and you’re realizing inflation behaving the way it can, you’re realizing you didn’t actually get it, you have to go back in. By then the risk really is that it has become entrenched in people’s thinking and the record is that the employment costs, the cost to the people that we don’t want to hurt, they go up with the passage of time.
There are two points to make. 1) It’s impossible to get this “exactly right” (and of course Powell knows that). Monetary policy operates with a lag of 2 to 4 quarters and the first hike was only in March, eight months ago. It reminds me of the scene in the Big Short where Lawrence Fields is demanding his money back, and Burry explains, “…the second quarter of 07 is when the adjustable rates kick in and defaults will skyrocket.” There are a lot of contracts that haven’t yet ‘kicked in’. 2) Powell has repeatedly said we have to stick with the program until we’re sure the job is done.
After the November 2 FOMC, SFRZ2/Z3 went to a high of 29 and a high settle of positive 21, in a nod to point 2 above. After CPI and the FTX meltdown the spread settled Thursday at -19.5 (9549.5/9569.0), a huge swing of 36 bps on the week, reflecting the idea that market forces may overwhelm Powell’s good intentions. As can be seen on the chart above, after the July 13 CPI release this spread printed -74 and has been gradually firming since then. The Thursday plunge indicates that tightness in financial conditions is filtering through the economy and will result in eventual ease. (Every 1-yr SOFR spread is inverted until Sept’25/Sept’26. The most inverted is June’23/June’24 at -109). The market is strongly hinting the Fed is too tight.
There was large selling (50k) of SFRU3 9550 and 9537.5 straddles after Thursday’s data around 84 to 83. What has occurred is a narrowing of possibilities regarding the future path of policy. Even if inflation levels begin to come down and the Fed is slowing down hikes, a long pause is more likely than easing. FFF3 settled Friday 9564.5 or 4.355%, very close to what will be the new EFFR of 4.33 on a hike of 50 at the Dec 14 FOMC. FFG3 settled 9531.5 or 4.685%, midway between 4.58 and 4.83, which would approximately price 25 or 50 at the Feb 1 FOMC.
SFRU3 settled Friday 9537.0. SFRU3 9550^ settled 84.75 (36.0/48.75) and 9537.5^ settled 83.0 (41.25/41.75). Atm EDU3 9512.5^ settled 83.0 (40.75/42.25) ref 9511.0, essentially the same nominal level as SOFR. One month ago, on 10/11/22, EDU3 9525^ ref 9524 settled 118.5 and the EDM3 9512.5^ ref 9513 settled 96.5. There has been a massive decline in premium since peak levels just prior to the October CPI release. Again, this decline was forcefully accentuated this week as policy expectations at the next two meetings have galvanized.
Below I’ve attached an infamous Business Week cover from August 1979. ‘The Death of Equities’. Of course, the market staged a strong rally in 1980. Also, the 1979 story was well after the 1974 plunge to new lows. However, one can make the case that times are quite similar. The article contains this excerpt:
To bring equities back to life now, secular inflation would have to be wrung out of the economy, and then accounting policies would have to be made more realistic and tax laws rewritten. But these steps may not be enough. “It will take two or three years of confidence building, of testing, before the market can seriously act like it did in the 1950s and early ‘60s,” says William J Fellner, a professor of Economics Advisers.
Interesting because of the inflation parallels and to confidence being wrung out of the crypto world. The rapid adoption of crypto currencies as an asset class has been due in part, to a lack of faith in policy makers and fiat currency. Perhaps gold will rightfully retake its place as the anti-establishment asset (up 5.3% this week). However, I certainly don’t think it’s safe to write about the demise of bitcoin. It’s likely nearer to the bottom than generally thought, though excesses will likely still take more leveraged players out.
It’s not ALL about the US. China takes the cake for overleveraged real estate. Here’s a clip from Reuters over the weekend:
BEIJING, Nov 13 (Reuters) – Chinese regulators have asked financial institutions to extend more support to property developers to shore up the country’s struggling real estate sector, two sources with direct knowledge of the matter said on Sunday.
A notice to the institutions from the People’s Bank of China (PBOC) and the China Banking and Insurance Regulatory Commission (CBIRC) outlined 16 steps to support the industry, including loan repayment extensions, in a major push to ease the deep liquidity crunch which has plagued the property sector since mid-2020.
Extend and pretend.
Empire Mfg amd PPI Tuesday.
Retail Sales, Industrial Production and the 20y auction on Wednesday
Housing Starts, Philly Fed and Jobless Claims Thursday
Existing Home Sales Friday
NOTE: WEEKLY CHANGES ONLY TO THURSDAY 11/10 SINCE FRIDAY WAS A HOLIDAY
| 11/4/2022 | 11/10/2022 | chg | ||
| UST 2Y | 464.6 | 432.4 | -32.2 | |
| UST 5Y | 432.0 | 394.1 | -37.9 | |
| UST 10Y | 415.0 | 382.7 | -32.3 | |
| UST 30Y | 424.3 | 404.3 | -20.0 | |
| GERM 2Y | 212.8 | 216.9 | 4.1 | |
| GERM 10Y | 229.5 | 201.0 | -28.5 | |
| JPN 30Y | 155.5 | 150.7 | -4.8 | |
| CHINA 10Y | 270.6 | 269.6 | -1.0 | |
| SOFR Z2/Z3 | 16.5 | -19.5 | -36.0 | |
| SOFR Z3/Z4 | -78.0 | -83.0 | -5.0 | |
| SOFR Z4/Z5 | -28.5 | -24.0 | 4.5 | |
| EUR | 99.84 | 102.09 | 2.25 | |
| CRUDE (CLZ2) | 92.61 | 86.47 | -6.14 | |
| SPX | 3770.55 | 3956.37 | 185.82 | 4.9% |
| VIX | 24.55 | 23.53 | -1.02 | |
