Fed Listens. Does it Hear?
May 19, 2019
Weekly Comment
On the week, both US and German ten year yields fell 6 bps, US to 2.393% and Germany to -10.4 bps. The German bund yield is now 5 bps lower than Japan’s JGB, which ended the week at -5.2 bps. Of course, Germany runs a budget surplus while Japan runs a huge deficit and buys every available bond. Switzerland’s ten year yield is -40 bps. US swap spreads have been trending lower since the middle of 2018, with the 2 yr at 6.25 bps, just holding barely above the historic low of 4 bps in late 2015. The 5 yr posted a low of -11 in 2015 and was slightly above +15 in 2018, and is now just 1.2 bps. The 10 yr hit +8 in 2018 and is now -4.6. In 2015 markets were in the midst of a commodity and emerging market sell-off. SPX was around 2000.
Three month libor is 2.52%, three month bills are 2.33% and again, the ten year is 2.39%. In its “Fed Listens” initiative, the Fed seems to spend a lot of time discussing a low and falling neutral rate while, at the same time, trying to talk up inflation expectations. Officials have repeatedly trotted out the idea of letting inflation ‘overshoot the 2% target’ while holding policy steady. It reminds me of the philosophical question, “If a tree falls in the forest and no one is around to hear it, does it make a sound?” If the Fed keeps talking about boosting inflation expectations and no one listens, do yields have to fall? When Powell became chairman, some commentators derisively noted that he wasn’t trained in economics, yet Powell’s Fed seems fixated on the theoretical constructs of the neutral rate and household expectations. Maybe that’s not exactly fair – when Powell became the Chairman, I think he genuinely wanted to separate the economy from the iron grip of over-valued asset prices which had become entrenched due to low funding rates He was attempting, I think, to move the economy away from Wall Street and back to Main Street. Events have overwhelmed this Fed.
Perhaps now the Fed will have to spend a bit more time on global financial plumbing. All sorts of prices don’t seem to make a lot of sense. In a recent interview, Jeffrey Gundlach was literally nearly pounding on the table expressing the view that bond vol is too low. The May tweak to IOER was a nod in the direction of unbalanced monetary flows. The unrelenting rally in back eurodollar contracts and in treasuries sends a powerful signal. On the eurodollar curve, EDH21 is now the highest contract, having traded above 98.00 this week and settled at 97.99. Since the middle of November, this contract has rallied 125 bps and it’s 50 bps below the current libor setting. In contrast. March’21 euribor has rallied about 60 bps since November, and is now 100.25.
The Fed points to all sorts of legitimate reasons for the neutral rate to be under pressure. Brainard in her last speech said, “the decline in the neutral rate likely reflects a variety of forces globally, such as the aging of the population in many large economies, some slowing in the rate of productivity growth, and increases in the demand for safe assets.” Huh? It’s equally plausible to say, ‘the unemployment rate is increasing because advances in technology and robotics are replacing jobs and holding down costs.’ Except that the unemployment rate is at a record low and all sorts of firms complain that skilled labor is in very short supply. By the way, Brainard’s May 16 speech was titled ‘The Disconnect between Inflation and Employment in the New Normal.’ [link below] It seems to me that the Fed is now in the reactive position of trying to fit its analytical framework around market actions. I think that some of these overwhelming market forces are a direct consequence of the zero-rate balance sheet expansion.
However, before continuing, it’s clear that the most immediate impact on markets has recently become the geopolitical trade wars. US equity markets bounce around with each and every ‘good cop/bad cop’ tweet out of the administration. However, the Chinese side appears to have lost patience with this approach and has slowly moved in one direction: harder. This past week, the state broadcaster CCTV anchor Kang Hui said, “If you want to negotiate, the door is open. If you want a trade war, we’ll fight you to the end. After 5000 years of wind and rain, what hasn’t the Chinese nation weathered?” According to a few news reports, that video was viewed over 3 BILLION times. Sounds like a little more than a squabble to me. Over the weekend the South China Morning Post said China is ‘in no rush’ for another discussion with Mnuchin until the US becomes more realistic. The yuan is close to testing the psychological 7 level.
Now, back to our regularly scheduled programming. This next chart isn’t really one for the Fed to ponder, it’s just a surprising item that was brought to my attention (thanks TW). It shows a new high in the gold/silver ratio. According to one article, 50% of silver’s demand is for industrial applications. So maybe this chart simply portends a further slowdown in the global economy. Or perhaps it reflects a demand for ‘safe assets’ (by Russia) for gold and bitcoin, which, according to Brainard, feeds into a lower neutral rate. Yeah. That’s it. In any case, I don’t care to think too much about the implications of this one. Except that maybe we should be looking at buying silver!
I reviewed an article written by Zoltan Pozsar of Credit Suisse from mid-February. At that time, he forecast that libor/ois spreads might tighten dramatically as funding costs relative to the treasury curve HAD to come down in order for the market to absorb significant increases in US supply. The current forward OIS/libor prices as indicated by the futures markets reflect this tightening. For example, EDM9/FFN9 has come down to 15.25 bps (9748.25 vs 9763.5). EDU9/FFV9 is 16.5 (9759.5 vs 9776.0). EDZ9/FFF0 is still 25.5 (9765.0 vs 9790.5). The main point of Pozsar’s note was that the US curve had to steepen rather dramatically in order to maintain sufficient foreign and domestic demand for increased auctions. The way that this adjustment has occurred is apparently through forward contracts (i.e. eurodollar futures) strongly inverting relative to the front end of the curve. While the Fed has been talking about inflation expectations, the curve has signaled the adjustment that Pozsar forecast in February. The market is telling the Fed that it has to continue down the 2019 path of more accommodative policy, and that rate cuts are a part of that equation. With October Fed Funds settling at 9776.0, 15 bps lower in yield than the front May contract (FFK9 = 9761), there is a 60% chance of an ease by September. (EDM9/EDU9 at -11.25 isn’t quite as aggressive). FFF0, the January contract, indicates certainty of at least one ease by the end of the year; at 9790.5 it is 29.5 bps below the front May contract.
In the absence of a resolution of the trade impasse, will a more accommodative Fed reinvigorate the stock market? Perhaps to some degree, but rate markets are already pricing this eventuality. Is it the Fed’s job to cushion the economy from political decisions? Maybe it is, in a reactive sense. But clearly one of the Fed’s objectives is to make sure the financial gears don’t start to lock up, and this latter concern is likely to become much more important over the medium term.
Note that on Monday, as part of the ‘Fed Listens’ program, NY Fed’s CEO and President, John Williams, is expected to give introductory remarks and Vice-Chair Clarida will give a speech on Monetary Policy Strategy, Tools and Communications. At 7:00 pm EST, Powell is slated to give a speech titled “Assessing Risks to our Financial System”. I would expect the emphasis to be on global financial risks that might feed into the US economy.
OTHER MARKET/TRADE THOUGHTS
June treasury options expire on Friday. TYM9 settled Friday at 124-155. Peak June call open interest levels are at the 124.5 and 125.0 strikes with 100k and 128k respectively. I expect a test of the 125 strike sometime early in the week. TYM9 125c settled 4/64’s. A couple of weeks ago I suggested that TUM9 might re-visit 106-24 from late March. Settled Friday at 106-18.75. While there has been pressure on the June contract due to heavy selling in the M9/U9 roll, odds favor a further grind higher.
Near Eurodollar one-year calendars posted new recent lows this past week with EDM9/EDM0 hitting -43.25. Odds favor further inversion. The reds have shown relative strength. Although the red/green pack spread is slightly inverted at -1.125 bp, the 9800 midcurve straddles are nominally higher in reds as compared to greens. For example, 0EU9 9800^ settled 35.5 with EDU20 at 9795.5, while 2EU9 9800^ settled 32.5 vs EDU21 9797.5.
There was large buying of Oct 9800/9825 call spreads last week; total position around 80k. Settled 2.25 ref EDZ19 9765.0. A lot can happen in five months. When the Fed becomes forced to ease, it can occur quickly. I don’t see any chance that the first move could be 50 bps, but I would not be surprised at all by two cuts of 25 at consecutive meetings. I think it would take an ‘event’ but it feels like one is getting closer.
| 5/10/2019 | 5/17/2019 | chg | |
| UST 2Y | 225.0 | 220.0 | -5.0 |
| UST 5Y | 224.7 | 217.8 | -6.9 |
| UST 10Y | 245.3 | 239.3 | -6.0 |
| UST 30Y | 287.4 | 282.4 | -5.0 |
| GERM 2Y | -61.6 | -64.6 | -3.0 |
| GERM 10Y | -4.5 | -10.4 | -5.9 |
| JPN 30Y | 53.4 | 52.4 | -1.0 |
| EURO$ Z9/Z0 | -26.5 | -31.0 | -4.5 |
| EURO$ Z0/Z1 | 1.0 | 1.0 | 0.0 |
| EUR | 112.35 | 111.59 | -0.76 |
| CRUDE (1st cont) | 61.80 | 62.92 | 1.12 |
| SPX | 2881.40 | 2859.53 | -21.87 |
| VIX | 16.04 | 15.96 | -0.08 |
https://www.federalreserve.gov/newsevents/speech/brainard20190516a.htm
