Oct 18. Monetary Lags

There’s a famous Milton Friedman paper about monetary lags, which he cited as “long and variable.” Policy makers have to first, identify the problem, second, respond to the problem with policy, and third, wait for the policy to take effect. Every one of those steps has a lag associated with it.

This week there was an interesting debate between the NY Fed’s Bill Dudley and John Taylor of Taylor Rule fame about whether to follow a rules-based policy (which eliminates some of the lags), or have a more activist Fed. Obviously, what we have now is the latter, and at times of increased financial stress there are, not surprisingly, going to be internal debates as to forward policy, which played out this week with Brainard and Tarullo speeches suggesting that the Fed refrain from tightening.

I reviewed a few academic papers on lags; this quote from a 2002 BoE piece sums it up: “We reaffirm Friedman’s result that it takes over a year before monetary policy actions have their peak effect on inflation.” .. “Bernanke, Laubach, Mishkin and Posen describe a two-year lag between policy actions and their main effect on inflation as a ‘common estimate.” *

I am no expert on policy lags, but consider what has happened in the year since QE tapering ended in October 2014. Since the onset of actual tapering in the beginning of 2014, commodities began their plunge, the dollar began to strengthen, inflation expectations began to fall. My view is that we are in the peak period of effects related to the end of QE. At the same time, as seen in the US budget data released this week, the Federal Gov’t, for better or worse, isn’t all that stimulative. [US Budget deficit at an 8 yr low of $439b]. As can be seen in the Fed’s Z.1 report, in the years between 2008 and 2013 the federal gov’t was a massive borrower to fill the gap for the private sector.** Now, the rate of fed’l borrowing has slipped to a growth rate of 5.4% in 2014 and just 2.4% in Q2 2015. Of course, we might say that’s as it should be, because the household sector has ended its deleveraging and Corporate Borrowing has bounced back and is expanding briskly from -1.2% in 2010 to +6.9% in 2014 and +8.5% average in the first half of 2015. The problem of course, is that much of the corporate borrowing has gone into share buybacks rather than productivity enhancing capital investment.

So, at the same time that fiscal policy has become less stimulative, we have the lagged effects of the end of QE and the forward looking response to a prospective rise in the funds rate. One of the effects/goals of QE is to force investors into riskier assets, to compress the spreads between, for example, corporate bonds and treasuries. What we are seeing now is the unwinding of those spreads, leading to tightened financial conditions as investors seek proper market-based risk parameters for corporate bonds (without the QE safety net). At the same time, with the threat of further tightening by the Fed, corporates borrowed more to lock in low rates, leaving corporate debt levels at a record dollar amount outstanding, $7.9T. An example of the end result is that the Baa corporate spread to 10 yr treasury moved from around 2.25 in early 2014 to around 3.25 now.

So what is the likely way forward? The market is obviously hyper-sensitive to changes in perceived central bank actions. The Sept FOMC announcement combined with a weak employment report vaporized the idea of a Fed hike this year, leading to powerful relief rallies in stocks and EM fx. Since the negative rate dot in the Fed’s Sept SEP, there has been relentless accumulation of ED 100 calls (0% strike) with 136k open in EDU6 and 122k open in EDH7. In the past week there were huge buyers of call butterflies in red midcurve June and Sept contracts, suggesting a slow grind flattening rally into next summer.*** The ten year yield is anchored around the halfway point of the year’s range which is 206; closed Friday 202.5. At 15.05, VIX is right back to the “fearless” level just prior to the August surge associated with China’s devaluation. Implied vol levels in treasuries are likewise at recent lows.

However, the dollar has gone sideways recently and is closer to the low of the year’s range rather than the high. Commodities are still weak, but are giving some indications of stabilizing. Similarly, the 5/30 treasury spread closed Friday at 152, near the year’s high, having started 2015 around 105 bps. The 5/30 spread almost appears to be a leading indicator, having topped over 250 in Q2 2013 as the taper tantrum peaked. It then declined through the end of 2014 to just over 100, and had a strong upward move in Q2 of this year to above 150. With the Fed likely on hold I think 5/30 should target 175 to 180 by year end, around the halfway mark of the 2013 high to 2015 low. The relatively long term trends of dollar strength and commodity weakness have likely run their course.

Given this thesis, the trades I favor are steepeners, like 5/30 mentioned above. In dollars, the red/gold pack spread settled 123 on Friday, only about 20 off the year’s low. Into 2016 I think this spread could move significantly higher. This year’s high has been near 160, which would be an initial target, and a move to 200 in 2016 seems reasonable.

In terms of the front end of the curve, I think two and five year yields are likely to move lower as the Fed’s internal debate forestalls any tightening over the near term, with the five year yield moving to 125 from the current 134.7.

It’s a fairly light news week in the US, with Housing Starts Tuesday and Existing Home Sales Thursday. International news could have the largest impact this week, with China GDP expected 6.5 to 6.7%. Additionally, the odds of a military accident between the US and Russia or even the US and China appear to have increased somewhat, with a possible flight to safety.

 

 

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10/9/2015 10/16/2015 chg
UST 2Y 63.9 60.9 -3.0
UST 5Y 139.9 134.7 -5.2
UST 10Y 208.9 202.5 -6.4
UST 30Y 291.8 286.5 -5.3
GERM 2Y -24.9 -26.9 -2.0
GERM 10Y 61.5 54.8 -6.7
EURO$ H6/H7 57.5 53.5 -4.0
EURO$ H7/H8 52.0 50.0 -2.0
EUR 113.58 113.50 -0.08
CRUDE (1st cont) 50.14 47.72 -2.42
SPX 2014.89 2033.11 18.22
VIX 17.08 15.05 -2.03
     
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*http://www4.fe.uc.pt/jasa/m_i_2010_2011/thelagfrommonetarypolicyactionstoinflation_friedmanrevisited.pdf

**http://www.federalreserve.gov/releases/z1/current/z1r-2.pdf

***+35k 0EM and 0EU 9925/9962/9987c flies for 11.5 as strip

Posted on October 19, 2015 at 5:08 am by alexmanzara · Permalink
In: Eurodollar Options

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