Nov 1. Fed has the chance to get communication back on track

With the Fed specifically mentioning the “next meeting” in its deliberations on whether to begin lift off, the market raised the odds of an actual hike in the funds target. However, the odds still don’t reflect more than a 50/50 chance of a December move. For example, January Fed Funds settled Friday at 9975, exactly 12.5 bps below the expiring October contract. San Fran President John Williams said the Fed included the “next meeting” reference just so that markets wouldn’t be surprised if indeed the Fed does hike. Still a bit squishy, but Yellen, Dudley and Fischer all speak Wednesday, providing the strong opportunity for guidance.

I went back and reviewed Lael Brainard’s Oct 12 speech, which was quite balanced, but concluded that asymmetric risks suggest the Fed should refrain from an early hike. This paragraph sums it up:

Now, take the alternative risk: that the underlying momentum of the domestic economy is not strong enough to resist the deflationary pull of the international environment. A further step-down in global demand growth and a further strengthening in the dollar could increase the already sizable negative effect of the global environment on U.S. demand, pushing U.S. growth back to, or below, potential. Progress toward full employment and 2 percent inflation would stall or reverse. With limited ability to ease policy, it would be more difficult to move the economy back on track.

The FOMC responded by dropping the sentence that global economic developments “may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” Dismissive of the risks.  It reminds me of (The Dictator) Admiral General Aladeen: “I love it when women go to school. It’s like seeing a monkey on roller skates – it means nothing to them, but it’s so adorable for us…”

Both market based and survey based measures of inflation are declining. I went back and compared the year 2012 with this year to date regarding economic releases. In 2012, NFP averaged 188k, this year 198k, a marginal improvement at best. Personal Income and Wages for both 2012 and 2015 look the same: sideways. PPI was positive throughout 2012, but this year has had two negative readings, the last being -0.3. The lowest CPI reading in 2012 was -0.2, the last in 2015 was -0.2. Industrial Production is weaker now than in 2012. So what’s stronger? Non-mfg ISM averaged around 53 in 2012 and this year 57.3. Auto sales (according to Wards) were around 11 million units in 2012, now 14.4 million. New home sales were running at a pace of 360k and are now 500k. Last but not least of course, is the stock market, with the SPX nearly 50% higher than its level at the end of 2012.

Let’s just consider car sales for a second. In 2012 (according to the Fed’s Consumer Credit release) the interest rate for a 48 month car loan was 4.91. Now? 4.11. In 2012 the maturity of a new car loan was 62 months. Now? 65 months. So, if the rate declines and the terms lengthen, the monthly nut declines. As they say on the floor, “It’s not rocket surgery.” But this trend also points up the loosening of standards that can lead to problems down the road. Which has been seen on a grander scale in the corporate bond market.

So the argument for hiking doesn’t really appear to be growth and wages, because those aren’t really making much of a move. It’s not inflation. It comes down to hoping that the ECB’s accommodation and China’s easing will spur the global economy, but more importantly in a domestic context, it’s about regaining a sense of financial risk and responsibility. As the Institute of International Finance succinctly puts it, “Easy policy has passed the point of diminishing return, and keeping it longer would only increase moral hazard and distort financial markets.”

What are the larger implications and ramifications of Wednesday’s speeches?   Yellen doesn’t really seem to have a bias to hike, but appears to have been swayed by the crowd. Dudley has already said his baseline scenario includes a rate increase this year. Fischer thinks zero rates are not normal, and that they could contribute to financial instability in the longer run. In assessing the market moves since the FOMC meeting, there was nothing to suggest that undue volatility would be associated with a hike. (First, do no harm). Stocks rallied. The curve flattened; ten year yields were up only 7 bps on the week. Crude oil closed up on the week. The dollar strengthened modestly. Even an average payroll report on Friday will provide the Fed with enough cover to pull the trigger. My implicit assumption is that the speeches this week will unify the Fed’s message and provide stable guidance.

It pretty much points to the inevitability of a hike even though the market may perceive it as a mistake. In all likelihood the dollar will strengthen a bit further. While the treasury curve may flatten initially, the promise of gradual or even glacial rate hikes will be repeated, causing any flattening to be short-lived. Spreads between corporates and UST will almost certainly widen. While an initial hike won’t do much to change short term funding rates, it may well signal regime change, putting financial stability right up there with growth and inflation mandates (in spite of what the Fed says). The window for borrowing to buy back shares may be closing. The goal is to let some air out of risk assets without engineering a reverse wealth effect on domestic consumption. It might end up being as important as hopes for a soft-landing in China.

One year Eurodollar butterflies jumped this week, as front one year spreads rose to new recent highs while back spreads remained idle. For example, EDH6/H7/H8 fly went to 10, having been as low as 2/2.5 early in the week. (EDH6/7 to a new high of 61, while EDH7/8 was unchanged on the week at 51). I am inclined to fade this move and would look to sell this fly if it can get back into the mid-teens.

In 2012 the average ten year yield was around 175. This year it’s just above 200. But the two year yield was around 20-30 bps and is now more like 60-70 (last at 73). The short end has generally adjusted higher. Indeed, the spread between the German Schatz and US 2 year widened to a new high this week of 105 bps. Regarding tens, I have often mentioned the midpoint of this year’s range, which is 206 and has acted as a magnet recently. In the longer term, the 2012 low is around 140, and the 2013 high is just over 3%, so that midpoint is 220, versus a close Friday of 215. For the rest of the year, I would look for a range of around 205 to 240. The caveat of course, is a big “risk off” scenario, caused by a global shock. There are plenty of imbalances out there that could act as a catalyst, both financial and geopolitical.

 

 

Net changes in selected markets below:

10/23/2015 10/30/2015 chg
UST 2Y 63.7 73.2 9.5
UST 5Y 143.0 153.0 10.0
UST 10Y 208.1 214.9 6.8
UST 30Y 289.6 293.2 3.6
GERM 2Y -31.9 -31.5 0.4
GERM 10Y 51.2 51.7 0.5
EURO$ H6/H7 54.5 61.0 6.5
EURO$ H7/H8 51.0 51.0 0.0
EUR 110.18 110.07 -0.11
CRUDE (1st cont) 44.60 46.59 1.99
SPX 2075.15 2079.36 4.21
VIX 14.46 15.07 0.61

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Posted on November 1, 2015 at 6:46 am by alexmanzara · Permalink
In: Eurodollar Options

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