May 22. Moneyball

The line in the April FOMC minutes that incited a surge to higher yields was this one, with its specific reference to June:  “Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.”

The minutes are presented with the ‘Staff’ first summarizing the economic and financial situations, followed by the Staff outlook.  In the ensuing section, the ‘Committee’ discusses the economic landscape and policy.  I can’t help but being reminded of the scene in Moneyball where the GM is listening to several seasoned coaches positively discussing a prospect, and then looks over at Peter Brand who just shakes his head ‘no’.  (Peter Brand is a fictional character who crunched all sorts of statistics to assess player value).  In this case the Fed staff is Peter Brand, and the Committee is composed of the old school, inside baseball, speech-givers.

Here are a couple of Peter Brand’s comments:

Forward-looking indicators of equipment spending, such as new orders for nondefense capital goods along with recent readings from national and regional surveys of business conditions, continued to be soft. Firms’ nominal spending for nonresidential structures excluding drilling and mining decreased in February. Indicators of spending for structures in the drilling and mining sector, such as the number of oil and gas rigs in operation, continued to fall through early April. The available data suggested that inventory investment moved down in the first quarter.

The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks. In addition, while there had been recent improvements in global financial and economic conditions, downside risks to the forecast from developments abroad, though smaller, remained.

In general, Peter Brand appears rather downbeat.  However, Billy Beane has the final say.  There are many interesting and somewhat contradictory passages throughout the minutes, mostly relating to the ‘Committee’.   These are in no particular order:

Some participants noted that global financial markets could be sensitive to the upcoming British referendum on membership in the European Union or to unanticipated developments associated with China’s management of its exchange rate.

…the recent depreciation of the dollar and indications of a rebound of economic growth in China appeared to reduce pressures on the renminbi.

 

Financial market conditions improved further, on balance, over the intermeeting period, with investors appearing to respond to Federal Reserve communications that were viewed as more accommodative than anticipated and to somewhat better-than-expected incoming data on foreign economic activity.

Many [participants] also thought that, as had apparently been the case in recent years, a low reading on seasonally adjusted first-quarter GDP growth could partly reflect measurement problems and, if so, would likely be followed by stronger GDP growth in subsequent quarters. However, some participants were concerned that transitory factors may not fully explain the softness in consumer spending or the broad-based declines in business investment in recent months.

Participants generally agreed that the risks to the economic outlook posed by global economic and financial developments had receded over the intermeeting period.

In short, the Committee is dismissive of some of the Staff’s concerns.  This, in spite of the fact that the Committee overtly acknowledges that “accommodative” communications in the second part of March helped ease financial conditions (including a further depreciation in the USD).  So, what will be the result of less accommodative communications?  My guess is that the dollar will strengthen (check), financial conditions will tighten (check), and that measures of net worth may begin to deteriorate (jury’s out, but here’s a pretty fascinating link regarding Net Worth: https://app.hedgeye.com/insights/50884-hedgeye-guest-contributor-thornton-my-scary-chart?utm_campaign=Market+Brief+1463670024&utm_content=Market+Brief+1463670024+CID_62a9e77f8c4c614fd32ae822b3196c77&utm_medium=email&utm_source=campaignmonitor+email

The minutes do NOT present a compelling case for tightening, though the market ratcheted up odds for a near term hike.  For example, May/June Fed Fund spread settled 4.0, about a 1 in 3 chance for a hike in June.  July/August FF spread settled 7.0, similar odds for a hike in July.  EDM6 settled 9927.25, which appears slightly cheap to me given the odds represented by Fed Fund futures.

While near Eurodollar one-year calendar spreads perked up on the week (for example EDU6/EDU7 jumped 5.5 bps to 31), all of the back spreads remain subdued.  Every 1-yr spread from EDM17/EDM18 back is below 25 bps.  The red/gold ED pack spread (2nd to 5th year) closed at a NEW low of 62 (flattest since 2007).  In treasuries, 2/10 closed near a new low at just 96 bps.  More importantly, the dollar index has made an outside range month (lower low and higher high than April) and closed near the high of the month.  An article on Bloomberg cites DB as saying this USD rally has legs to run further.   China’s yuan closed at its weakest level since the start of March.  And there was disagreement at the G7 on the Japanese Yen, with US Treasury Sec’y Lew arguing that movements in the yen were not “disorderly”, and Japan’s FinMin Aso saying, “I told (Lew) that recent currency moves were one-sided and speculative.”  The Brexit vote still looms.  All in all, while it can be technically claimed that global financial risks have “receded”, the magnitude of change has been miniscule.

Now, I don’t want to fight the Fed.  After all, many analysts have cited a change in the narrative.  It’s not as though the guidance from Central Banks remains constant.  For example, Greenspan used the phrase “irrational exuberance” but thought the Fed’s role should be reactive, to mop up after the fallout of asset prices that didn’t appear to make sense.  Recently the Fed has turned to macroprudential tools to stem excesses.  I should note that the initial section of the minutes deals with just this topic.  But here’s an actual line that quickly diminishes any confidence one might have in regulatory fixes:  “Participants emphasized the importance of macroprudential tools in promoting financial stability, and they generally expressed the view that such tools should be the primary means to address financial stability risks. However, it was noted that relatively few macroprudential tools are available to financial regulators in the United States and that, for the most part, such tools are untested.”

My own opinion is that there is zero chance of a hike in June due to Brexit concerns, but that there will likely be a hike in July.  The dollar index, having been in a 16 month range of 92 to 100, and having just tested the lower end and bounced, will move toward the upper end of the range.  Oil will move sideways to lower, as will US equities.  Risks from China are probably higher than the Fed acknowledges.  The curve will remain flat due to hawkish rhetoric and other factors.  While the prospect of better data in the beginning of June could pressure tens, 2% or just above will act as a cap.  In futures, the spike to 128-00 which was the March FOMC low in TYM, should be a solid support area.

Posted on May 22, 2016 at 8:42 am by alexmanzara · Permalink
In: Eurodollar Options

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