Mr. Market Questions the Fed
Feb 28. 2021- Weekly comment
I didn’t watch much of Powell’s testimony this past week. But I did happen to catch CA Representative Brad Sherman’s monologue. This guy has been in Congress for thirty years. He starts by praising the ‘Fed Listens’ program and tells Powell, “I assure you your best ‘Fed listens’ event is right here. You will not find fifty people in better touch and more representative of the 320 million Americans.” In the next two minutes he brutally displays just how out of touch he actually is. He likes Powell’s ‘big balance sheet expansionary policy, and says “I would hope you would be looking at 2 ¼% rather than 2% as your target” Really? Why? He conveniently leaves out the word “INFLATION” target. I guess he thinks it’s better to reduce American’s purchasing power by another ¼% annually rather than just 2%. He goes on to commend Powell for QE, saying “…it has allowed you to remit to the Federal Gov’t $50 to $100 billion in each of the last several years…” Free money, right Brad? So, interest on the debt that is swapped between branches of the government is commendable? Continuing, “…QE and your big balance sheet approach is the only tool you have to influence long term rates, which I think are more important to the economy…” That’s how it works, huh? Maybe the Fed should just cap long-term rates. Finally, “I prefer monetary policy to expansionary fiscal policy because all of your tools reduce the federal deficit and all our tools increase the long term deficit.” All of the Fed’s tools reduce the federal deficit? What? This guy heads the entrepreneurial and capital markets subcommittee, yet he breathtakingly shows utter ignorance about how the Fed, capital markets and the economy work. I wouldn’t let Brad run a lemonade stand. He tells Powell, “I’ve grown old on this committee. I’ve heard your predecessor’s predecessor’s predecessor…” And should have added, AND I HAVE LEARNED NOTHING.
Here’s the link. 40:50 to 42:43.
https://www.youtube.com/watch?v=NIQ5moocXzM
So why does Brad Sherman make a difference? Because sometimes policy makers just don’t grasp what is going on around them. On this week of the Fed’s semi-annual Fed testimony that’s my takeaway. For example, Powell was completely dismissive in his response to a question about 25% yoy growth in M2, saying “there was a time when monetary policy aggregates were important determinants of inflation and that has not been the case for a long time. …the correlation between different aggregates [like] M2 and inflation is just very, very low and you see that now, where inflation is at 1 ¼% for this year.”
A comment from Steve Hanke: “Chairman Powell is clearly delusional. I can’t believe the Chairman of a central bank actually said that. Broad money measures are linked very closely to nominal GDP and nominal GDP includes real economic growth plus inflation.”
Powell is not delusional. He is so focused on regaining full employment that all other scenarios are being ignored, and he believes that an increase in inflation will allow debtors to gracefully service heavy burdens. This week should be interesting with respect to Fed thoughts. On Monday, Brainard, Williams, Bostic, Mester and Kashkari participate on a virtual panel. On Tuesday Brainard discusses the economic outlook, and Daly speaks to the Economic Club of NY. Evans on Thursday. Powell discusses the economy on Thursday, and payrolls are out on Friday.
Below I highlight a few changes on the week that reflect changing sentiment. The market is pulling forward the idea of Fed tightening. There was so much volume on the week that CME stock actually bucked the trend and closed higher despite renewed talk of a transaction tax. There were a couple of large TUM1/FVM1 block steepeners on Wed and Thursday just prior to the poorly received 7-yr auction which contributed to an epic 13.2 bp jump in 2/5’s (details at bottom). Let’s take a couple of moves Friday to Friday. I include marks from Thursday since that afternoon featured some extremes after the dismal 7-yr auction.
2/19 2/25 2/26 change
2/5 treas spd 46.5 64.0 59.7 13.2
10/30 treasury 79.2 74.7 74.1 -5.1
Red/Grn ED 34.375 50.375 50.875 16.5
Grn/Blue ED 56.125 58.625 58.625 2.5
Blue/Gold ED 46.125 39.375 37.25 -8.875
The steepness moved forward on the curve. The December FOMC had the FF projection at 0.1 through 2023. The market has pushed the idea of a hike forward by at least one year. The red/green Eurodollar pack spread jumped 16.2 bps! Reds are the 2022 contracts and Greens the 2023 contracts. That spread finished the week at 50.875; two hikes. If the Fed is on hold for two years but then in play, it makes sense that 2/5’s widened: 2’s were up 3.3 bps, but uncertainty in the next three years caused 5’s to jump nearly 18 bps.
If the Fed is forced to hit the brakes sooner than previously expected, then perhaps term premium and inflation premium should retrace some of the recent moves. Indeed that’s what happened. 10/30 treasury spread declined 5 bps and the closely related blue/gold Eurodollar pack spread (4th to 5th year forward) fell by almost 9 bps.
In my view, implied vols between fives and thirties captures the sentiment. As I have highlighted before, after March, US vol exploded relative to FV vol. The Fed was expected to have things under complete lockdown for three to four years, which pushed relative uncertainty into the long maturities. As a rule of thumb, the DV01 on the FV contract is about $55 and in the bond more like $200. In general, the ratio of DV01 US to FV is near 4. Should US vol be 4 times higher? No, because the action is usually in the belly of the curve. But after March, US vol became much greater than 4x more than FV vol. Following are several marks of this ratio of atm vols, US/FV.
Feb 23, 2020, 2.97. That is, bond vol 3x greater than FV vol; this is pre-pandemic
Apr 23, 2020, 5.30. Bond vol now significantly above a long term average relative to FV
Feb 19, 2021, 4.19. This is the Friday before last
Feb 26, 2021, 3.19. Friday’s close; getting back to ‘normal’
For anyone interested I will send a chart on Monday. In the early part of this year the ratio was 6, I believe the highest I saw over the past year was around 7.
The Fed Effective rate (EFFR) has been 7 to 8 bps through February, equating to 9993 to 9992 in FF prices. FFH1 settled 9993.0. The farthest out FF contract for which there is open interest is February 2023, and that settled 9972.0, a difference of 21 to the FFH1 contract 2 years forward, indicating 1 hike. In the beginning of this year FFG3 was 9987. In May many FF contracts traded above 100, at slightly negative yields.
OTHER MARKET THOUGHTS/ TRADES
In general, vol has been quite directional, which argues for long TY call ratios, buying lower leg, looking for small yield retracements.
| 2/19/2021 | 2/26/2021 | chg | ||
| UST 2Y | 11.0 | 14.3 | 3.3 | |
| UST 5Y | 59.2 | 77.1 | 17.9 | |
| UST 10Y | 134.1 | 145.1 | 11.0 | |
| UST 30Y | 213.6 | 218.0 | 4.4 | |
| GERM 2Y | -68.1 | -66.3 | 1.8 | |
| GERM 10Y | -30.5 | -26.0 | 4.5 | |
| JPN 30Y | 68.4 | 75.1 | 6.7 | |
| CHINA 10Y | 326.6 | 328.0 | 1.4 | |
| EURO$ M1/M2 | 6.0 | 8.5 | 2.5 | |
| EURO$ M2/M3 | 27.0 | 44.5 | 17.5 | |
| EURO$ M3/M4 | 60.5 | 65.0 | 4.5 | |
| EUR | 121.20 | 120.74 | -0.46 | |
| CRUDE (active) | 59.26 | 61.50 | 2.24 | |
| SPX | 3906.71 | 3811.15 | -95.56 | -2.4% |
| VIX | 22.05 | 27.95 | 5.90 | |
WED BLOCK +28815 TUM 110-145/ -40569 FVM 124-25 FV is approx. $2.25million DV01
TH BLOCK +23062 TUM 110-115 / -18835 FVM 124-09.25 just over $1 million DV01
