Sept 18. Return to a Reflation Trade
Let’s start with a couple of changes on the week. The five year US treasury yield jumped 18.2 bps to 1.82%. The ten year yield was up 13.6 bps to 2.201% (the move was even larger given intraday lows on Sept 8; tens hit 2.015%). January 2018 Fed Funds fell from 9878.5 to 9872.5. That 6 bp move represents an increase in odds for a hike by the end of the year from 25% to 50%. Eurodollar one-year calendar spreads also rose, with the peak one-yr spread EDZ17 to EDZ18 now at 30 bps, a gain of 8.5 on the week. SPX closed at a new high just above 2500, and the dollar index, at 91.84 remains close to the low of the year.
This week brings the FOMC meeting with a press conference and SEP, Summary of Economic Projections. It’s widely expected that the Fed will announce the onset of the Balance Sheet Adjustment plan, details of which were laid out at the June meeting.* Given recent Fed speeches, notably Brainard’s, it wouldn’t be surprising to see the longer term ‘dots’ revised lower, as evidence mounts that the neutral rate has declined. As of the June meeting, the end of year projected FF rate for 2017 was 1.4%, 2018 2.1%, 2019 2.9% and longer term 3.0%. If the longer term dots are revised lower, there will likely be some reaction in the curve, though I suspect only temporary. The fact is, even though the Fed controls FF’s, their own members’ forecasts have been miserable. According to the year-end dots as published, EDZ17/EDZ18 spread should be more like 70 bps (the difference between 1.4 to 2.1 as projected). The actual spread is 30. EDZ18/EDZ19 is just 18, as opposed to the difference in year-end dots of 80 bps. Nothing really new here, as the market has pretty much ignored the dots for a long time. What is new is the Bank of England’s shift to a more hawkish outlook, following close on the heels of a surprise hike by the Bank of Canada. There is a potential change in Central Bank sentiment occurring.
Instead of trying to decipher macroeconomic nuances and central bank communications, I’m just going to focus on a couple of charts. Below is a chart of the Russell 2000 small cap index, overlaid with the NFIB small business optimism index. These two track pretty well. After the election of Trump, small business sentiment skyrocketed. The Russell also took another leg up. What’s somewhat interesting is that in spite of a decline in Trump’s approval ratings, small business confidence (as reflected by both NFIB and Russell) has never wavered. From the last report, NFIB’s Chief Economist Dunkelberg said, “Small firms are now making long-term investments in new machines, equipment, facilities, and technology. That’s a real sign of strength, and it will be interesting to see if the August result becomes a trend.”
In other markets and indicators, the Trump surge, based on expectations of relaxed regulations along with health and tax reforms, completely fizzled out. For example, the dollar index started 2017 at a new high, but gave away the post-election rally and more, and is now near a new low. Multi-year lows.
Same thing with US rates. In March the ten year treasury hit 2.62%, but this month ticked 201.5, as noted above. The yield curve paints the same picture. As a specific example, below I have included a chart of ED5 to ED9, the fifth quarterly euro$ contract vs the ninth. Given that EDU17 expires Monday, 18th Sept, this spread will now be represented by EDZ18/EDZ19.
Euro$ 5th to 9th qrtrly spread
The spread itself is in the bottom panel of the chart. In the post-election surge, the spread topped at 54, having been in the upper teens in early November 2016. It took a round-trip this year, having gotten down to 16 in the week before last. This coming week, 5th to 9th will become EDZ18/Z19 which settled at just 18 bps on Friday, having bottomed at 14.
What we have seen over the past week is 1) a jump in treasury yields, 2) new highs in stocks, 3) further gains in market measures of forward inflation – for example, ten year tip/treasury breakeven ended at a new recent high over 186 bps, 4) a move by Trump to work with Democrats, 5) an admission by Speaker Ryan that tax reform may not be ‘revenue neutral’, 6) expectations of stimulus spending related to storms, 7) continued weakness in the dollar, 8) a related increase in commodity prices with WTI up 2.41 on the week near $50/bbl, 9) a relaxation of rules which will make it easier to short the Chinese yuan, which indeed weakened in response, 10) a forward push in the rate hike timetable by the BoE.
By the way, last week I said that “according the Fed Funds futures curve, the first fully priced rate hike does not show up until April of 2019…that’s nineteen months! “ That timetable has also been pushed forward, with the first fully priced hike now the July 2018 contract at 9859.5, ten months away. The Fed isn’t pushing the timetable up, the market is. It’s worth noting that by this time next year there will likely be a new Fed chair, with new Governors.
The point of the above discussion is simply this: The Eurodollar curve has probably flattened way too much since Q1. Along with the ten year yield (which declined as the Fed hiked), back month Eurodollar contracts only went higher as the Fed raised in Dec, March and June. Again, in looking at the chart above of 5th to 9th ED, the upper panel shows the prices of the two contracts. The lower (amber) line is, of course, the first green. On the hike last December this contract traded 9780. Now, with an additional TWO hikes it’s 9807 (EDZ19).
For this week’s FOMC we expect no hike and the start of QE’s normalization. On a risk/reward basis, buying reds and selling deferred contracts looks attractive for a substantial move. The risk is that a new Fed Chairman might be more prone to quickly raising FF’s, thereby flattening the curve, though I would think the Trump administration will try to focus on soft-money candidates.
