Bullard now irrelevant
May 5, 2022
–“…a 75 bp increase is not something the committee is actively considering.” With that rebuke, Powell effectively sidelined Bullard, who had been the primary advocate of aggressive hiking. We can now disregard Bullard’s speeches as interesting, but on the hawkish fringe, irrelevant for policy, just as Kocherlakota occupied the dovish fringe in his time on the Fed. Stocks soared, the curve steepened.
–Just prior to the FOMC, May Fed Funds were trading around 9921 to 21.5, indicating at least some chance of 75. On 50 they immediately went to 23/23.25 (settled 9923.0) as those fears went unrealized. However, July Fed Funds remained right were they were, at 9851.5/52. That is, the spread between May and July, which prices the June 15 and July 27 FOMC was about 71.25 to 71.5 bps. Assuming 50 bps at the June meeting and the July meeting (which is worth 6.5 bps to the contract) would yield a spread of 62.5… that is, FFN2 should be more like 9860.5 (if I’ve done the math right*). As the press conference started, FFN2 actually traded down to 9847/47.5, indicating an INCREASE in the odds of 75. When Powell made his “not actively considering” comment, FFN2 immediately traded up to 9857/57.5 where the contract settled. Surprisingly, FFN2 is slightly lower this morning at 56.5/57. I highlight this front end pricing because it explains larger moves. For example, the two year note yield plunged by 15.4 bps to 2.614…if 75’s are off the table, there was too much priced. But the prospect of large hikes also had been the catalyst for flattening, and the unwind of that possibility caused sharp steepening. The 30 yr yield was nearly unchanged and tens only fell 4 bps to 2.915. This dynamic is also apparent on the dollar curve: reds (2nd yr forward) were +15.5 and golds (5th yr) were +2.75. Implied vol was crushed. For example, red atm straddles fell around 10 bps. TYM atm straddle went from 8.8 to 7.7 although declines in July premium weren’t as pronounced.
–Stocks rejoiced in a relief rally, though the fundamental backdrop isn’t particularly encouraging. Some are hoping for a repeat from the March FOMC, which marked a bottom in stocks and subsequent ripping rally thru month-end (4200 to 4600 in SPX). Jury is out, but overnight declines suggest a similar rally is unlikely this time around.
–With respect to the steepener, it’s somewhat interesting to note atm nominal straddle levels in midcurves. Because of the risks of aggressive near term hikes, the nominal levels of red straddles have been higher than deferred. This is still the case at yesterday’s settles. For example, 0EU2 9662.5^ (EDU3 underlying) 75.0s, 2EU2 9687.5^ (on EDU4) 70.5s and 3EU2 9700^ (on EDU5) 67.5s. The strikes are higher in back due to inversion, and the straddle prices are lower (with the same amount of time left). This pricing, in both the curve and straddle levels should begin to shift if the market really believes Powell is slowing it down. Similarly, FV vol should begin to ease relative to US.
*Fed Effective was 33 bps going into the FOMC. With a hike of 50, the new EFFR should be 83. So for May Fed Funds (FFK) 4 days at 33 bps and 27 days at 83 is 76.5, that is, a price of 9923.5. For July, if there is a 50 bp hike in June, EFFR goes to 133, and another on July 27 is 27 days at 133 and 4 days at 183 yields 139.45 or a price of 9860.55.
