Fed: transitory. Market: Not transitory

March 7, 2021 – Weekly Comment

For a while, I was using 2018 as a guidepost for levels regarding economic activity and prices.  This was the euphoric period following Trump’s tax bill, when the Fed was in the process of simultaneously tapering and raising the FF target, i.e. ‘normalizing’.  Last week, data from ISM Mfg and Services surveys showed prices have easily eclipsed 2018, with comparisons now going back to 2008.  By the way in 2018, the Fed hiked the FF target in June to 1.75-2.0%, in Sept 2.0 – 2.25%, and in December 2.25 – 2.5%.  The current ten-yr yield is only 1.55%.

The markets and the Fed don’t have any dispute about the path of prices in the near term.  They are going up.  The critical issue is whether general price increases are sustained, leading to accelerating inflation, or are transitory.  The Fed of course, is in the latter camp.  Powell has made more than a few comments indicating that’s his base case.  For example, regarding the semi-conductor chip shortage that idled some auto manufacturing plants, he said the prices might go up for cars in the short term, but inflation is a year after year increase in prices, and he didn’t expect that.  Same thing with respect to housing: covid altered people’s preferences for housing which led to a temporary increase in prices.  Both Brainard and Powell referred to base effects in the past week, but deemed them transitory.

The market, on the other hand, is leaning heavily toward the idea of accelerating prices.  Not only will the Fed get its 2% target, but there is overt concern that the target will be exceeded.  By a lot.  For the second week in a row, many curve measures finished at new highs.  Premium levels fell in the early part of the week but roared back on Friday.    I am updating the data I used last week:

                                2/19                       2/26                       chg to 2/26          3/5                         chg 2/26 to 3/5
2/5 treas spd     46.5                        59.7                        13.2                        64.5                        4.8
10/30 treasury  79.2                        74.1                        -5.1                        73.3                        -0.8

Red/Grn ED        34.375                   50.875                   16.5                        51.5                        0.625

Grn/Blue ED       56.125                   58.625                   2.5                         62.75                     4.125
Blue/Gold ED     46.125                   37.25                     -8.875                   42.87                     5.625

Let me mention a couple of levels I was involved with in ED’s.  EDM2 9900p, paid 2.5 ref 9976.0 on Thursday.  Settled 2.75 vs 9977.0.  These are 1 ¼ years away.  Consider the levels: EDM2 is 23 bps vs current 3-month libor around 18.  The futures market is more or less taking the Fed at its word of no hikes within a couple of years.  One might think 1 bp would be a more appropriate price for the 1% strike, but demand for protection has increased. 

On Friday EDU2 9900 puts traded 5.0 and 5.5 ref 9967.5/68.  They settled 5.5 vs 9970.0.  Again, the futures price, which is a year and a half forward, is just 12 bps above the current libor rate.  On Friday prior to the NFP release, there was a buyer of >30k 0EU 9962.5 puts for 6.0 to 6.5.  Settled 7.0 vs 9970.0 with an increase in open interest of 63k.  These midcurves settle on 10-Sept 2021, and at 7, the breakeven is, of course, 9955.5, or 44.5 bps, just over ¼% away from the current libor marks. 

These are some pretty juicy levels, but maybe they’re not juicy at all if the Fed is thrown into another round of disarray.  The Fed agonizes over past mistakes in order to avoid repeating them.  In 1994, they hiked too rapidly and caused the tequila crisis.  (There were probably other issues, but I happen to like tequila).  I recall a big bond local Tom Baldwin, who initially faded the move, but then just shrugged and said the waves of bond selling were obvious and decided to jump on.  In the 2004 to 2006 hiking cycle the Fed was entirely predictable and slowly boiled the frog, hiking 25 at every meeting, though I don’t think they’ve ever re-examined that flattening episode in the context of a mistake.  The recent repo surge in 2019 caused a slew of soul-searching papers and comments from the Fed…something NOT to be repeated.  In 2018, hiking while ratcheting up the taper was a mistake that resulted in the hard equity break at the end of that year.    

I feel as if the current period, with the Fed having changed its framework in August of 2020 and focused on employment rather than inflation, all at a time when fiscal jets are firing and covid is on the wane, is going to be the mother of all mistakes.  The Fed is well aware that official yoy inflation data is going to ramp up, in part due to base effects from last year’s March and April data falling out.  Just as a small example of how yoy figures can be impacted, Reuters reported that China’s “Exports in dollar terms skyrocketed 154.9% in Feb compared with a year earlier…”

These are difficult levels to short fixed income, especially in light of the magnitude of the move so far.  News articles are rampant about treasury fails and the -4% repo rate.  The Fed is promising to keep rates low and has the YCC bazooka in the back pocket for now.  While the SLR exemption is expected to expire March 31, there are other measures the Fed could initiate to entice banks to buy treasuries.  The RBA increased its bond purchases last week and Kuroda at BOJ made comments to stop the rise of Japanese yields.  However, market flows are telling you to initiate shorts.

The two over-arching issues are inflation (boosted by growth) and supply.  ZH had an article citing mining.com about lithium carbonate prices being driven by battery demand.  “Benchmark’s global weighted average lithium hydroxide prices are up 8% ytd…”  “While lithium’s majors are beginning to reengage in expansion plans, three years of falling lithium prices have failed to incentivise sufficient investment into the supply chain…”  There is one article after another highlighting this dynamic: lack of investment in productive capabilities because low rates made financial engineering more profitable.  Now supplies become an issue as demand ramps up.

WTI crude ended the week over $66/bbl.  CPI and PPI are released Wed and Friday, with Core yoy expected 1.4% and 2.6% respectively.  Treasury auctions 3s, 10s and 30s this week in the amounts of $58b, $38b, $24b.  FOMC is March 17, the Fed is now in the quiet period.

UST 2Y14.313.9-0.4
UST 5Y77.178.41.3
UST 10Y145.1155.410.3
UST 30Y218.0228.710.7
GERM 2Y-66.3-69.0-2.7
GERM 10Y-26.0-30.2-4.2
JPN 30Y75.166.9-8.2
CHINA 10Y328.0324.9-3.1
EURO$ M1/M28.57.0-1.5
EURO$ M2/M344.545.51.0
EURO$ M3/M465.068.53.5
CRUDE (active)61.5066.094.59
Posted on March 7, 2021 at 8:20 am by alexmanzara · Permalink
In: Eurodollar Options

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