Uncertain, but economy strong (for now)

June 19, 2022 – Weekly comment

A couple of excerpts from Powell’s press conference:

the economy often evolves in unexpected ways.

And we will strive to avoid adding uncertainty in what is already an extraordinarily challenging and uncertain time.

So remember how highly uncertain this is, but that [a restrictive level] is generally a range of 3 to 3.5%.

So, for much of the yield curve now, real rates are positive.  [tips]

The consumer’s in really good shape financially…There’s no sign of a broader slowdown that I can see in the economy. …consumer confidence is very low.  That’s probably related to gas prices and also stock prices to some extent for other people.  …ultimately it does appear that the US economy is in a strong position and well-positioned to deal with higher interest rates.

…financial conditions have tightened over the last seven months and that’s a good thing, we think. But the FF rate, even after this increase is at 1.6%.  So it’s hard to see how that is too high of a rate and even if we did another, so we’re going to get here by the end of the summer, somewhere in the twos probably.  Still, that’s a low rate.  So, that’s not a rate this is calculated to bring a recession on. 

Just a couple of notes on the above. Uncertainty is the watchword, but Powell thinks the economy can withstand an inflation-fighting Fed.  The objective is to get to a restrictive level of 3 to 3.5% by the end of the year.  However, in Q4 2018, stocks — and the economy in general — couldn’t handle QT and rate increases, which met a forced end at 2.25 -2.50%.  Powell often says that expectations are a powerful determinant in terms of inflation and the Fed has a primary goal of anchoring those expectations at 2%.  I personally think that “expectations” and “confidence” go hand in hand, but Powell is dismissive of the impact of low consumer confidence on the economy, saying the US is in a strong position and able to handle higher rates. 

He says, “…if you look around the world at where inflation levels are, it’s absolutely extraordinary. It’s not just here.  In fact, we’re sort of in the middle of the pack…” 

If the US is really the only country dead set on stopping inflation, which is a global phenomenon, doesn’t that imply extraordinary USD strength? (DXY ended the week 104.65, marking a new high since 2002). Perhaps the weekend plunge in bitcoin to sub-18k as tether became untethered, is an indication.  From a mid-May Forbes article, “It is difficult for Tether to follow the path of Terra completely because if they decide to take out even 30% to 50% of their collateral, that will shake up not only the crypto market but also the broader financial markets,” says Kavita Gupta, founder of Delta Blockchain Fund.  “…Tether’s site states that ‘All Tether tokens are pegged at 1-to-1 with a matching fiat currency and are backed 100% by Tether’s reserves.’  Typically, this is when we find out that the reserves were of dubious value.

Powell pegged the July meeting at either 50 or 75 and Waller is out this weekend supporting 75.  August Fed Funds settled 9771.0 or 2.29%.  With last week’s 75 bp hike, EFFR set at 158.  Another 75 in July would mean 233, so FFQ2 is leaning heavily toward that outcome.  Further out, the market is clearly erasing hikes next year, as EDU2/EDU3 is the only positive one-year calendar spread until EDZ5/EDZ6 (2.5s).  EDU2/U3 settled 43.5, exactly halving its value on the week, and EDZ2/EDZ3 settled -28.5, a plunge of 34.  The most negative one-year calendar on the ED strip is EDM23/EDM3 at negative 45.5.  I.e. in one year from now, the market is loosely projecting 50 bps of rate CUTS.  Of course, that would be from higher base rates than now, as EDH3 is the lowest contract on the strip at 9601, just under 4%; EDM3 is 9607.

There are all sorts of warning signs of recession ahead.  The Atlanta Fed GDP Now Is 0.0 for Q2.  Back end ED and SOFR calendars are inverted.  The 5/30 treasury spread is also inverted at -4.7 (3.338% and 3.291%).  At the end of May 5/30 was 24 bps, it reached a low on Tuesday of -17.  SPX has fallen 10.5% in the past two weeks.  Credit spreads are widening.  According to the St Louis Fed, CCC & lower high-yield effective is 14.25%.  From Axios: “If a CCC bond is going to be 13 or 14%, that really changes the math for private equity sponsors.  It’s really hard to make it work,” Christopher Miller, director of capital markets at Neuberger Berman.  While 14.25% is about double the average from 2021, the covid high in 2020 was about 20%. Energy prices took a huge tumble last week as emphasis on demand destruction skimmed some froth.  CLQ2 closed 107.99 down 8.5% on the week.  July NatGas plunged over 21% on the week.  July RBOB -9%.

While treasury yields finished higher, the week ended with a FI bid, as a flight into safety developed.  Unlike everything else on the curve, the thirty-year bond this week did NOT exceed the high-water mark in 2018 which was 3.455%.  The week’s high was 3.427%, so for now, a double top is in place with a test of 3% likely to occur over the near term. (Friday close 3.29%). In late 2018 as stocks sold off, thirties went from 3.45 in the beginning of November to 2.90 on Jan 3.  Ultimately, bonds rallied through 2019, but this time, the Fed appears to have new-found resolve on squeezing out inflation.  SFRU2 settled 9691.0 or 3.09%, meaning by Q4 positive carry will be priced out.  SFRZ2 settled 9641.0 or 3.59%; higher than everything on the treasury curve; the high point is the 20y which ended at 3.53%.  It may become more difficult to place treasury debt into the hands of the private market without the benefit of a positive yield curve. Declines in long rates will probably be limited. (SFR contracts refer to SOFR, the Secured Overnight Financing Rate which is the funding rate on treasuries).

It’s now two weeks from the end of Q2. Many ‘wealth managers’ suggest not even bothering to look at the returns on one’s long term portfolio, except perhaps quarterly.  Anyone who compares end of March to end of June is likely to be somewhat shocked. 

News this week includes Existing Home Sales on Tuesday, expected 5.4m from 5.6.  New Home Sales on Friday, expected 592k from 591k.  In late 2020 New Home sales hit a rate of over 1m, and to start this year 839k.  The doubling of the 30y mortgage rate this year is unambiguously biting. 

Powell delivers semi-annual testimony on Wednesday, which will be followed by the 20-yr auction (re-opening). Barkin speaks several times this week, starting with an interview on Tuesday.  Evans, Harker and Barkin on Wednesday afternoon.  Powell again on Thursday, followed by Bullard and Daly on Friday.   

UST 2Y304.7316.211.5
UST 5Y325.1333.88.7
UST 10Y315.6323.78.1
UST 30Y319.3329.19.8
GERM 2Y97.1109.412.3
GERM 10Y151.6166.114.5
JPN 30Y108.7116.88.1
CHINA 10Y279.4281.42.0
EURO$ U2/U387.043.5-43.5
EURO$ U3/U4-39.0-38.50.5
EURO$ U4/U5-21.0-17.04.0
CRUDE (active)118.12107.99-10.13


Posted on June 19, 2022 at 11:51 am by alexmanzara · Permalink
In: Eurodollar Options

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