Successful Execution of a Plan
August 29, 2021- Weekly Comment
How successful was Powell?
On the week the ten year rose 5.2 bps to 1.31%. That’s less than the increase in the German bund of 7.2 bps. 2/10 rose to 108.5, up a bit over 7 from the previous Friday, but still below the high for August of 113.5. 5/30 ended at 112, up 3 on the week, but that level is still right around where it was at the last Jackson Hole conference in 2020. I.e. it is still near the low of the last twelve months, with the intervening high being 163, set in February.
By these measures, one might say that Powell was spectacularly successful in his Jackson Hole communications. He told the market that taper will probably start this year while barely rippling interest rates, even in the face of the highest PCE deflator in a decade (4.2%, equal to the high in 2008). One has to look back to 1991 to see higher PCE inflation data.
The Eurodollar curve gives additional evidence that Powell deftly conveyed the message that taper in no way defines a cycle of rate hikes. I like to look at one-year calendars and butterflies to determine how the market interpreted the chairman, but the libor transition date at the end of 2023 has put a large kink in the curve. Let’s simplistically say that changes in one-year calendars are a rough proxy for how the market views probabilities for rate hikes. EDZ’21/EDZ’22 settled Friday at 24.5, down 2 on the week. Since March, this spread has been between 14 and 33.5 on settlement basis and is now essentially in the middle. The high of 33.5 was made after the hawkish dot-plot at the June FOMC. Friday’s close is almost exactly equal to one 25 bp rate hike. Even with the prospect of taper starting soon, the market did NOT push up near term rate hike probabilities. All of the midcurve put insurance purchases on EDZ’22 suddenly became less valuable. By far, the most open interest in any midcurve puts is in Short Dec on EDZ’22 (0EZ1) with 2.3 million. If we include Short Oct and Nov (0EV1 and 0EX1) on the same underlying EDZ’22 contract, there are over 3.1 million puts open.
Let’s look further back. EDZ’22/EDZ’23 spread settled 58.0, up 3.5 on the week. The spread encompasses the libor cessation at the end of June, 2023. To give a rough idea of magnitude, note that EDH’23 to EDM’23 is a spread of 14.0 bps while EDM’23/EDU’23 is 21.5. This latter spread (M3/U3) captures the transition period and is easily the highest 3-month spread on the curve. So let’s take the difference between the two spreads and say that libor cessation is worth about 8 bps, which then means, in its absence, EDZ’22/EDZ’23 would be 50 bps, essentially forecasting two 25 bp hikes over that year. Again, when thinking about it in terms of Powell’s goals, with the near spread declining on the week and the more deferred spread increasing, he was able to successfully push odds of hiking a bit further out on the curve, while keeping the absolute level completely restrained. I find it amazing how much control the Fed’s narrative seems to have over this market. Again, the highest PCE deflator in the past 30 years was released last week!
Just for a bit of historical context, the 4th to 8th ED quarterly contract calendar hit a high of 243 bps at the end of 2001! Coming out of the GFC in late 2009, the 4th/8th one-year calendar was 163. In 2011, 145.5. And in late 2014, 112. Now the 4th/8th is EDM’22/EDM’23 and it’s 49.5 bps. After libor/sofr adjustment EDZ’22/EDZ’23 is at about the same level.
Now consider EDZ’23/EDZ’24, green/blue Dec. On the week this calendar rose 3 bps to 33.5. The spread increased, but it scarcely indicates persistent inflationary concerns. In fact, EDZ’22/EDZ’24 which traded 118.5 immediately after the hawkish June 16 FOMC and settled 117 on that date, is now 93.5.
Larry Summers had this to say on a Bloomberg interview following Powell’s speech: “But I was struck, for example, that he didn’t say anything about the housing sector. That’s the largest part of the consumer price indices. I saw a statistic… that said on average, when a tenant moves into a rented residence, they’re paying 17% more than the old tenant. That suggests a lot of rental price inflation.” [that hasn’t yet been reflected in CPI].
This moves us into the tin foil part of our presentation. Or, aluminum foil. Or anything you can make an appropriate hat out of.
According to LME rolling three month forward contracts, tin is up 33.8% year to date, and aluminum 32.5% ytd or 53% annualized. It’s even getting more expensive to protect against conspiracies and insidious brain invasions. (I’m hoarding inventory). Speaking of which, Financial Times has a headline plastered on its website: “Why Blackstone made a $5bn bet on housing low-income Americans.” Yeah, that’s a real head-scratcher. (take hat off first). Gee, the CDC eviction moratorium was overturned, which will likely spark Congressional action to provide rent support. Summers notes rampant rental inflation. A BBG article over the weekend says, “The Biggest Landlords are Driving Pandemic Evictions” [though it does not mention Blackstone or Blackrock, link below]. Why is Blackstone buying rental property? Just following Blackrock’s lead. Because when you can influence government policy in support of direct rental payments that are rampantly inflating, it no longer is a “Bet” but more of a “Lock”.
This is the aspect of Fed policy that is not a success, but is in the category a Pyrrhic victory, one “that inflicts such a devastating toll on the victor that it is tantamount to defeat.” Oh, it certainly doesn’t look like defeat at this moment, with asset prices screaming to new highs and inflationary pressures broadening. That is, it doesn’t look like defeat to the Fed. However, if one reviews previous Fed speeches, you might note that feel-good references to the goal of increasing inflation were equating ‘inflation’ as it was loosely used, to ‘wage increases’. In hindsight, that was disingenuous, because the cost of living is outpacing wage gains, though not of course, outpacing gains related to financial assets. Powell’s noble goal of getting back to full employment is exacerbating cost-of-living disparities between wage earners and the owners of financial assets.
Grade on the goal of not causing turbulence in interest rate markets as taper moves closer to reality: A
Grade on the prospect of creating future financial instability because of artificially low rates: D
OTHER MARKET THOUGHTS/ TRADES
Imagine how much military hardware needs to be replaced due to the weaponry ceded in Afghanistan. Imagine how much more military supply is going to actually be used up in the near term. It’s called fiscal stimulus, and at these rates, we can just put it on the credit card.
The week ahead features employment data, with NFP expected 750k. If data is weaker than expected, the curve will probably flatten. Even if it’s stronger than expected, the front end probably doesn’t have much life to it. Sept midcurves expire 10-Sept, the Friday following the Labor Day holiday. 3EU 9862.5p settled 3.0 vs 9871.5, providing reasonable downside protection in the event of another big payroll day. 2EU 9906.25p settled 3.5 ref 9910.5 in EDU’23.
| 8/20/2021 | 8/27/2021 | chg | ||
| UST 2Y | 24.2 | 21.5 | -2.7 | |
| UST 5Y | 79.7 | 79.8 | 0.1 | |
| UST 10Y | 125.8 | 131.0 | 5.2 | |
| UST 30Y | 187.2 | 191.7 | 4.5 | |
| GERM 2Y | -74.8 | -73.5 | 1.3 | |
| GERM 10Y | -49.5 | -42.3 | 7.2 | |
| JPN 30Y | 64.0 | 64.7 | 0.7 | |
| CHINA 10Y | 284.8 | 287.3 | 2.5 | |
| EURO$ Z1/Z2 | 26.5 | 24.5 | -2.0 | |
| EURO$ Z2/Z3 | 54.5 | 58.0 | 3.5 | |
| EURO$ Z3/Z4 | 32.5 | 35.5 | 3.0 | |
| EUR | 117.01 | 117.97 | 0.96 | |
| CRUDE (active) | 62.14 | 68.74 | 6.60 | |
| SPX | 4441.67 | 4509.37 | 67.70 | 1.5% |
| VIX | 18.56 | 16.39 | -2.17 | |
https://blinks.bloomberg.com/news/stories/QYJQKHDWRGG4
