Dec 18. Fed signals slow and steady policy of accommodation removal
–Yields rose Wednesday as the Fed signaled rate increases starting in the latter half of 2015. Belly was weakest, with 5’s up 6.6 bps to 159 and the green euro$ pack -8.375. 5/30 treasury spread notched a new low just under 115. Powerful rallies in high yield debt and small cap stocks. The idea that stocks “are the only place” to park money, an argument that I am not particularly fond of, rings true for now as the dollar rallied and as the Swiss, for example, have introduced negative rates on deposits, apparently to discourage the flood of Russian capital seeking safety. EURCHF sits right at the 120 peg and EUR yesterday weakened at the end of the day, closing below 123.50, near recent lows. Low inflation, a strong dollar and high liquidity make US stocks attractive to a world that needs a safe haven.
–The Fed appears to be taking great pains to convince the market that any rate hikes will be gradual, and the market agrees, as there is no one year euro$ calendar spread above 100 bps. The peak spread is EDU15/EDU16 which rose 5.5 bps to 99.5. The Fed continues to see the deceleration of inflation as transitory, though in the SEP, it’s interesting to note that in September, the Fed’s guess for PCE inflation for 2015 was 1.6 to 1.9, and this time they revised it down to 1.0 to 1.6. We’ve all known market makers like that right? “Hey where are you in these calls?” “2 bid/at 3” “OK now where are you? I have an order…” “Oh now I’m 1/5”. I’m not disparaging market makers, just noting that the Fed’s projections have been poor, and I guess they’re hoping to finally get something right by widening out the estimates. I should however, note that Core inflation projection only went from 1.6-1.9 in Sept to 1.5-1.8 currently.
–The point is that the Fed is on a steady path in its goal to remove accommodation, even if inflation remains low. Clearly to Fed has no control over the disintegration of the ruble and of oil, and little influence on the tenuous politics of the ECB. My contention is that the plunge in oil will tend to slow the economy going forward, that the US consumer will NOT be a counterweight, but that perhaps gov’t spending will provide a partial offsetting boost. Small rate hikes can easily be absorbed over a long period.
–Implied vol was much softer. For example, EDM5 9962^ was 17.5/18 early in the day and ended 16.0/16.5. All back month and midcurve straddles fell 1.5 to 2 bps.
–Today’s news includes Job Claims expected 295k, PMI Services 57.3, Philly Fed 25.0 and LEI at +0.6.
