Echoes of 2007

July 28, 2024 – weekly comment
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Is the SOFR futures curve correctly forecasting the Fed’s easing schedule?  My answer is that it provides clues, but the main takeaway is only that we’re getting closer to rate cuts, and the inversion in the near one-year calendar, SFRU4/SFRU5, at a level of -128 bps, near a new low, is a market signal that provides substantial cover for the Fed to commence easing the FF target.  That is, the 1-yr forward SFRU5 contract at 9624 or 3.76% is over 1 ¼ pct lower in yield than the near SFRU4 contract at 9496 or 5.04%.

There seem to be some parallels between now and 2007, when the Fed initiated the first ease in September.  At that time, unsustainable indebtedness was being shouldered by the household sector, mostly in the form of adjustable rate mortgages.  Currently, the debt problem is arguably larger, but is centered on the Federal Gov’t, radiating out to the rest of the populace. 

Below I simply briefly compare similar one-year calendars in two time-frames: going into the first ease in 2007 and now.  In 2007 the benchmark short-end futures were Eurodollars, and now it’s SOFR, but the spreads are similar.  The chart below is the 1^st quarterly to 5^th quarterly ED on a rolling basis. 

The period from mid-June 2007 to mid-Sept would have been EDU07/EDU08.  The spread declined somehat aggressively stating in August, moving from -44 to -130.  Was -130 “right”?  The first ease was 50 bps, and in less than eight months the FF target was cut from 5.25% to 2% (yellow to red vertical lines).  The inversion was of course, warranted, but -130 was nowhere close to capturing the ultimate magnitude of easing.  It was pretty obvious at that time that there were serious financial stresses that ballooned in August,  Here’s a link to Bernanke’s Jackson Hole speech on Aug 31, 2007.
https://www.federalreserve.gov/newsevents/speech/bernanke20070831a.htm

Here are a couple of interesting snippets:
In the statement following its August 7 meeting, the Federal Open Market Committee (FOMC) recognized that the rise in financial volatility and the tightening of credit conditions for some households and businesses had increased the downside risks to growth somewhat but reiterated that inflation risks remained its predominant policy concern.

On August 17, the Federal Reserve Board announced a cut in the discount rate of 50 basis points and adjustments in the Reserve Banks’ usual discount window practices to facilitate the provision of term financing for as long as thirty days, renewable by the borrower.  The Federal Reserve also took a number of supplemental actions, such as cutting the fee charged for lending Treasury securities.  The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity.  Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets

Clearly, at the August 7, 2007 FOMC, the Fed didn’t grasp the severity of the situation.  Cramer did though, having gone on an epic “They [the Fed] know nothing!!” rant on August 3, 2007.
https://www.youtube.com/watch?v=TaKnDMv6ceg

From the August 7, 2007 Fed statement (emphasis added.  Can’t always believe what they tell you):
Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20070807a.htm

Is now like then?

There was a post on X the other day:

Tell me why again there should be an aggressive easing cycle with:
* Real GDP growth at 2.8%
* Core PCE price growth at 2.9%
* Stocks up double digits this year and just off all time highs
* Spreads near secular lows

My response: IN 2007:
Real GDP Q3 2.3% .
Core PCE prices 2.0 in Q3, 2.8 in Q4. 2007
YTD SPX +9.5% by July.
BBB corp spd was 1.31 in June’07, 1.26 now.
We know what happened at end of 07 and 08. Not saying it’s the same…BUT IT COULD BE

The only point of this tiptoe through the past is to examine one little ear-mark of financial conditions, the one-year SOFR calendar spread, to see if the signals are similar.  From the end of May until now, the spread has declined from -68 to -128.  A slight echo of August 2007.

Chart of the current rolling spread below.  Note, in euro$’s, we used 1^st to 5^th, but in SOFR, because the ‘first’ quarterly continues to trade past the IMM date, we use 2^nd to 6^th.

The FOMC next week is likely a dead issue.  Unlike 2007 there are NOT obvious signs of stress coursing through financial firms.  The exact opposite could be argued.  However, the lower end of the consumer spectrum is pulling back quickly, and the political situation is creating some degree of angst.

The only real conclusion is that the past isn’t always a burden, but we can learn a few things about possible outcomes from it. 

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October Fed Funds settled 9495, assuming that Wednesday’s FOMC is dead, a 25 bp cut in September would mean a new Fed Effective of 5.08%, leading to a final settle in FFV4 of 9492.  The market is indicating small odds of a 50 bp cut (like 2007) at the Sept meeting.  I would guess that some time after Wednesday’s FOMC, this contract will trade 9502, indicating a 50/50 chance between 25 and 50 bp ease.

In March’25 SOFR, peak call open interest is represented by the 9675/9775cs which settled 5.25 ref   9575 (both strikes around 225k open). 

This week’s news includes the Treasury Refunding Announcement and Wednesday’s FOMC meeting. Employment report on Friday. 

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	7/19/2024	7/26/2024	chg
UST 2Y	446.3	438.9	-7.4
UST 5Y	414.8	408.0	-6.8
UST 10Y	423.9	419.8	-4.1
UST 30Y	445.0	445.5	0.5
GERM 2Y	278.4	262.2	-16.2
GERM 10Y	246.7	240.7	-6.0
JPN 20Y	183.1	182.7	-0.4
CHINA 10Y	226.0	219.0	-7.0
SOFR U4/U5	-122.5	-127.5	-5.0
SOFR U5/U6	-29.0	-30.0	-1.0
SOFR U6/U7	-1.0	-0.5	0.5
EUR	108.85	108.60	-0.25
CRUDE (CLU4)	78.64	77.16	-1.48
SPX	5505.00	5459.10	-45.90	-0.8%
VIX	16.52	16.39	-0.13

• ABOUT:
  Former member of the CME specializing in interest rate options and yield curve strategies.

  The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results.