July 16, 2017. Third Mandate of Financial Conditions Recedes

“It’s almost an embarrassment be an American citizen traveling around the world and listening to the stupid sh-t we have to deal with in this country…” Could be worse Jamie. Could be Greek. Oh… Nevermind. Sorry about that Mr Papademetriou.

I had thought the curve would steepen after the June FOMC because I thought it was going to be a dovish hike given mushy economic data. Instead, the curve flattened. The dovish stuff is coming out now. First Brainard on Tuesday: “In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term,” Brainard said. “If that is the case, we would not have much more additional work to do on moving to a neutral stance. Then Yellen in her comments on Wednesday: “…our view that the federal funds rate remains somewhat below its neutral level. …Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.” Then on Friday, Kaplan with “we want evidence of inflation progress before hiking again.” Inflation measures have fallen off again, with YOY CPI just 1.6% Friday (Core was 1.7). Retail Sales were -0.2%. The odds of a Sept hike fell to 10% and a hike before year end is now priced only at about 50/50. Below is a chart of the FF target and a couple of market measures of inflation, the ten yr note/tip spread and 5y5y forward inflation swap.

But what about the Fed’s dots? Well, those are just a loose guideline. Anyway, now it’s all about financial conditions and risks to stability, right? Some analysts even termed ‘financial conditions’ a third mandate. Well, as the Fed de-emphasized that point over the past week and rather, chose to highlight soft inflation, it was an engraved invitation to sell the dollar and buy equities. Stocks made new highs. VIX sank to 9.51. Especially perky was the Emerging Markets etf EEM, which soared nearly 6% from the previous Friday’s low on almost daily gap opens. Of course, Dimon’s subtle reference to the political circus which is short on substantive policy progress is another USD negative. (DXY lowest close since August of last year).

Now I want to focus on a different part of Yellen’s testimony. She said “We think that our purchases of assets during the QE years around the financial crisis did have some positive effect in depressing longer term interest rates. And, so over many years, as our balance sheet shrinks, we would expect to see some increase in long term interest rates relative to short term interest rates. But of course, we will take that into effect, namely the steepening of the yield curve, in how we set the fed funds rate, which will become, is now, and I hope will remain, our primary tool for adjusting the stance of monetary policy.”

A comment from Ben Hunt of Epsilon Theory is more succinct, and more rooted in reality: “My point is a simple one. In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory.” *

Both of these snippets get to the same core. QE depressed long term rates because it siphoned off investment in capital equipment for leveraged ‘investment’ in stocks and other financial assets. It removed the inflation premium. It removed risk premium. In a closed textbook world, the marginal buyer, the Fed, drives up price and lowers yields and spurs borrowing and capital investment. In the real world corporates got the message on borrowing at low rates, but never saw true economic opportunities. ‘How ya left?’ With record corporate debt as a % of GDP and diluted balance sheets (outside of cash-rich tech titans). Yellen wants to gingerly wind down QE in a way that will be almost unnoticeable. However, by embracing the FF rate as the primary Fed tool, she’s sending a much more opaque invitation to sell bonds. Back to Dimon again, “When that [unwinding of QE] happens of size or substance, it could be a little more disruptive than people think.”

I was gently heckled after last week’s comments calling for higher rates at the long end. But, I’m doubling down this week. Although on Friday USU traded to a new high on the week of 153-16, by the end of the day it was trading a point lower at 152-13, less than a point away from the recent low of 151-18. When Yellen started her testimony on Wednesday, USU was around 152-08. All interest rate futures rallied from there, but the bond is near that initial level even with the soft inflation and retail sales data.  At the futures settlement time (USU7 152-20s), I marked 5/30 spread at 105 bps. This had been a long term support area. [Chart below] On June 13, the day before the last FOMC, 5/30 was 108.5. By the end of June it had sunk as low as 92, but as of Friday it’s more or less testing the breakout level. It’s either a great sell level here or an indication that the flattening after the Fed was the final capitulation.

I’ll end with a quote from another Greek, this one being 12 years old but amusing nonetheless, from George Economou, CEO of DryShips, as noted in FT Alphaville: “Because Americans are the dumbest investors around, and there’s lots of liquidity in this market.” The FT mentioned DryShips because of an interesting piece in the Wall Street Journal detailing new financial gymnastics by Economou. ‘Plus ça change, plus c’est la même chose.’ Good read; this guy’s almost as creative as the central banks in building false value.



* http://wolfstreet.com/2017/07/13/what-will-the-fed-do-jobs-productivity-inflation-qe-tighten/

Posted on July 16, 2017 at 1:34 pm by alexmanzara · Permalink
In: Eurodollar Options

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