The Sellsword

At the December 19 FOMC, Powell said: “I think that the runoff of the balance sheet has been smooth and has served its purpose.  I don’t see us changing that.”  He added, “We’re alert to these issues, watching them carefully.  We don’t see the balance sheet runoffs as creating significant problems.”

On the following Friday, Dec 21, Williams, interviewed by Steve Liesman said, “…if there’s a material deterioration in the economic outlook, obviously we will reconsider our path for the short term interest rate and would adjust policy to best achieve our goals.  But we also said we would reconsider the balance sheet normalization and may even end that process…if that’s appropriate to achieve our goals.” 

In my weekly note at the time (Dealings of my trade, Dec 23) I wrote, ”I think the Fed will deliver an ‘ease’ by the beginning of next year, in the second quickest turnaround since the crash of 87.  They will probably try to wait for the January 30 FOMC.  Using the cover of enormous treasury supply, the Fed will announce either a trimming of the balance sheet reduction to something like $20 billion per month, or a complete cessation, most likely the latter.”    

On January 4, Powell, at the American Economic Ass’n, promised that the Fed would “…be prepared to adjust policy quickly and flexibly and to use all of our tools to support the economy…” which was a signal the Fed was on hold in terms of rate hikes.  With respect to the Fed’s balance sheet, he said at that time, “We don’t believe that our issuance is an important part of the story of the market turbulence that began in the fourth quarter of last year.  But, I’ll say it again, if we reached a different conclusion, we wouldn’t hesitate to make a change.”

In my weekly note on Jan 7 (Flexibility) I wrote, “…the Fed has certainly bought time until the January FOMC to determine if changes need to be made.  My guess is that they WILL tweak the balance sheet schedule at the January meeting unless there is concrete progress made in China trade negotiations.” 

Vice Chair Richard Clarida, on Thursday of the following week, Jan 10, echoed Powell and solidified the pause.  On balance sheet normalization: if it no longer promotes dual mandate goals “we will not hesitate to make changes.”   

Other Fed officials have kept to the same script.  Unsurprisingly risk assets levitated.  Then on Friday, Jan 25, we got the Wall Street Journal plant: ‘Fed Officials Weigh Earlier-Than-Expected End to Bond Portfolio Runoff- Next week’s meeting could yield more clues.’ 

So, the market now anticipates an end to QT.  Stocks surged on Friday, as did gold (new high for the year over $1300) and copper (looks to have found a bottom). SPX has reversed nearly all of December’s loss.  The Emerging Market etf, EEM has completely reversed the fall in December, as have junk bond funds HYG and JNK.  Not long ago, analysts were talking about financial conditions as a quasi ‘third mandate’ for the Fed.  Powell didn’t want asset prices to be the primary driving economic force.  However, the pressure generated by a sharp pullback in stocks has apparently cast Fed members under the spell of rising stocks as a magic elixir.  Having already guided the market to a pause in March with respect to the FF target, can the Fed stop balance sheet normalization in January cold-turkey? 

The first non-quarterly press conference this week promises to be a dilly. If the Fed were to trim the balance sheet run-off in January, it would be the fastest hike to ‘ease’ turnaround since 1987.  If Powell leaves the schedule as is and simply says the Fed is considering changes, what will the March FOMC look like?  A pause with an extra dollop of stimulus by cutting QT?  I assume the WSJ article was a part of the Fed’s communication strategy.  But it is threatening to backfire.  If the Fed ends balance sheet normalization, it’s an overt admission that they don’t understand the transmission effect.  If they hew to the schedule of $50 billion per month, the new risk is severe market disappointment.  The most likely outcome in my opinion is the announcement of a modified, decreasing quarterly schedule of run-off, in much the same way as QT was instituted. For asset prices, buy the rumor and sell the fact.  

In Game of Thrones, Varys poses a riddle to Tyrion: “In a room sit three great men, a king, a priest, and a rich man with his gold.  Between them stands a sellsword, a little man of common birth and no great mind.  Each of the great ones bids him slay the other two. ‘Do it’ says the king, ‘for I am your lawful ruler.’  ‘Do it’ says the priest, ‘for I command you in the name of the gods.’ ‘Do it,’ says the rich man ‘and all this gold shall be yours.’  So tell me – who lives and who dies?”

Which master shall the Fed serve?  Trump, Main Street, or Wall Street?  “Power resides where men believes it resides. It’s a trick.  A shadow on the wall.”  The Fed is holding the sword, but the struggle for alliances is getting messy, the message is becoming muddled.  By the way, Varys looks a lot like Uncle Fester of the Addams Family.  Don’t box yourself into the comedic role of Uncle Fester, Chairman Powell. 

Uncle Fester

It’s worth a mention as well that the PBOC is also taking incremental steps to ease.  For example, at the end of last week, the central bank announced a swap facility for perpetual bonds issued by commercial banks.  There perpetuities can be swapped for central bank bills.  I.e. switch long dated assets of dubious quality for fresh, short-term, top-credit bills to improve Tier 1 capital ratios and support the ability to lend more.  Liquidity transformation and transmission.  Draghi also tilted the balance of risks to the downside.

The ironic aspect of the Fed’s about-face regarding QT is that actual rate hikes could once again become more likely, especially if asset prices keep running.  Does the market indicate that?  Not really.  EDM9/EDU9 rose 1.5 on Friday to a new high of +1.5, but that barely shows sign of tightening concern.  May/July Fed Fund spread (which would fully capture a Fed move in June) settled 4.0, actually one bp lower than the previous Friday.  Aug/Oct FF settled +1.0. 

Interestingly, the red/green Eurodollar pack spread (2nd to 3rd year forward) had a low settle this week of -7.75 and closed at -7.5.  As the chart below shows, this is near the low since the turn of the century, and indicates a tight central bank, rather than one that is becoming increasingly dovish.  Other curve measures have declined, but aren’t quite probing new lows. 

Red/green euro$ pack spread since 2000

The market seems to be saying that the Fed is essentially out of the picture, and we’re still ‘on’ for recession about a year from now. 

Debt Ceiling

On March 1 the government’s suspension of the debt ceiling limit ends.  Various estimates expect the deficit to be about $22 trillion at that time.  According to a recent paper (great read and summary)  by Andreas Steno Larsen and Martin Enlund, come March, the Treasury will begin withdrawing its cash balance at the Fed, “…as they cannot hold an ‘above normal’ liquidity buffer ahead of the expiration of the debt ceiling suspension.  The commercial banking system will be on the receiving end of this USD liquidity, which should be temporarily positive for risk appetite.”  The authors anticipate a weaker dollar and tighter libor/ois as a result.!/article/47454/week-ahead-earnings-recession-time

In terms of debt, the treasury is cramming heavy issuance into the early part of the week prior to Wednesday’s FOMC.  On Monday, $40b 2-yrs and $41b 5-yrs are auctioned.  On Tuesday, $20b 2yr FRNs and $32b 7-yrs.  FOMC on Wednesday and Employment data Friday. 

1/18/2019 1/25/2019 chg
UST 2Y 261.2 259.8 -1.4
UST 5Y 261.8 258.7 -3.1
UST 10Y 278.2 274.9 -3.3
UST 30Y 309.4 305.9 -3.5
GERM 2Y -58.1 -58.0 0.1
GERM 10Y 26.2 19.3 -6.9
JPN 30Y 69.3 65.2 -4.1
EURO$ H9/H0 2.5 1.0 -1.5
EURO$ H0/H1 -10.5 -12.5 -2.0
EUR 113.64 114.13 0.49
CRUDE (1st cont) 54.04 53.69 -0.35
SPX 2670.71 2664.76 -5.95
VIX 17.80 17.42 -0.38
Posted on January 27, 2019 at 1:01 pm by alexmanzara · Permalink
In: Eurodollar Options

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