March 17. FOMC WEEK- FED CAN’T CONTROL EVERYTHING
Last week I suggested supply and demand was about to become more important in the treasury market. It’s a good topic, and would have been spot on if I had been talking about short term funding markets rather than longer dated treasuries. Because that was really the story this week, the continued blow-up of Libor/OIS. A Bloomberg article noted the Fed asked about the widening in its most recent dealer survey. This piece continues, citing BAML, “Central bank would be ‘much more concerned’ about the rise in Libor if it reflected increased bank credit concerns rather than supply/demand dynamics at the front end of the rates curve.” Since EDH8 expires Monday, as good a reflection of widening as any is the spread of EDH8 to FFJ8, which settled 55.5. This is out from a low of 41 earlier in the month. On the forward curve, EDM8/FFN8 settled 47, EDU8/FFV8 39 and EDZ8/FFF9 at 38.5. The cited culprits for this widening are repatriation flows and t-bill issuance. Glancing at EEM (emerging market etf), there doesn’t seem to be undue pressure on emerging markets. Recall that in 2015, EM stress forestalled the Fed from hiking in September; Yellen waited until December ‘15 for the first hike of the cycle. In any case, we are seeing evidence of tightened financial conditions throughout the markets. The NY Fed considers short and long term rates, equities, the value of the dollar, and corporate spreads as indicators of stress. All have signaled increased tightening. Even though the curve has flattened, both short and long rates have increased. The dollar has steadied for now, stocks have lost a little air. Many regional Fed banks have their own indicators, and they’ve turned up modestly. I am just going to include a chart from the Chicago Fed.
Hard to see, but the black line, which represents Adjusted Nat’l Financial Conditions Index, is edging a bit higher. What is sort of interesting is the orange part of the chart, which is the ‘adjustment’. I’ve isolated that on the chart below. When this moves into positive territory, as it is now, it seems to indicate problems ahead. As I understand it from the Chicago Fed website, this adjustment seeks to put financial conditions in the context of general economic conditions. Probably worth noting.
Actually, real time economic data likely provides much the same sort of information. For example, the deceleration in Retail Sales immediately caused downward revisions in Q1 GDP. In the wake of the report, the Atlanta Fed Q1 estimate plunged from 2.5% to 1.9% and then down to 1.8% on Friday. The NY Fed NowCast was also revised to a new low of 2.73%, having been 3.11% one month ago.
This week brings the FOMC. I have seen a few analysts say that the Fed is going to lean hawkishly, and perhaps telegraph four hikes. My only response is, ‘Why would anyone conclude that?’ Financial conditions are tightening. The increase in libor funding rates has already had the same effect as an overt rate increase. If one were inclined to forecast 4 hikes for the year, they’ve got it. January 2019 FF contract trades 9784.0. Given the current Fed effective of 1.42% and FFF9 indicating a rate of 2.16%, the difference of 74 bps indicates 3 hikes. Add in the 25 bp widening of libor/ois and, sure enough, there’s the 1%. Inflation scares have slightly abated, given tameness in average hourly earnings. However, I will note that the NY Fed’s Underlying Inflation Gauge (UIG) increased to 3% at last reading for January, which is the highest it’s been since prior to the crisis. But the Fed is not so narrowly focused.
There is one other little technical note regarding the Fed Effective. It has been as solid as a rock at 142 bps excluding month end, but ticked to 143 on Thursday. April FF traded 9833 Friday, reflecting a fear that Friday’s Fed Eff could also tick higher. Really, FFJ shouldn’t be trading 9833 and the fact that it is indicates another little technical wrinkle, of which we’ve seen many recently.
For example, there were deliveries into UXYH8 this month as the delivery option kicked in. The conversion factor is so low on the Cheapest-to-deliver that the post 2:00pm rally on 6-March when Cohn resigned created an option for the short to deliver and cover the additional long tails for a tidy sum. I’ll also mention the EDZ9 9800 conversion that caused a local kerfuffle last week. Traded 0.5 for call with futures level of 9800. It had settled 1.75, which reflects the carry of 21 months, as the actual futures price was 9711.5. The locals which sold at 0.5 weren’t (amazingly enough) incorporating higher yields over time in their market. Is this trade of particular interest? Not really, one local group picked off a couple of others. The point is, this stuff doesn’t typically happen, and in a way, it’s GOOD. It reintroduces the idea of RISK into financial dealings. Perhaps it’s tied to the thought that central banks are taking a step back from the babysitter role. Higher rates and dislocations make people think twice. Well some, anyway. A result should be higher option premia. This environment makes people say, “Are you sure that’s there?” Whenever I get that question, I say “Let me just double check,” because I’m not really sure of anything in this world.
Quick mention regarding the dollar. It seems to be attempting to base, or at least it isn’t going down from here. The lagged effect of USD weakness over the past year is one of the factors that should drive inflation readings higher. But if US rates continue to rally, then shouldn’t the dollar turn higher? Note that the yield spread between bunds and US tens is 227 bps, which is the high of the year and nearing the peak set in late 2016 of 235. That particular spread hasn’t really had much influence on USD. On the other hand, the yield difference between EDM8 and ERM8 has moved nearly 100 bps in six months. From around 178 bps in September 2017 to 273.5 currently. One would think this widening should support the USD, and, the prospect of increased pressure on the short end could provide a further push. However, think of the converse for a second. What if something happens that causes the US front end to rally? Then USD may be subject to another hard leg down.
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| 3/9/2018 | 3/16/2018 | chg | |
| UST 2Y | 226.2 | 229.1 | 2.9 |
| UST 5Y | 265.2 | 264.3 | -0.9 |
| UST 10Y | 289.7 | 284.6 | -5.1 |
| UST 30Y | 315.0 | 308.0 | -7.0 |
| GERM 2Y | -55.6 | -59.1 | -3.5 |
| GERM 10Y | 64.8 | 57.1 | -7.7 |
| JPN 30Y | 76.3 | 75.3 | -1.0 |
| EURO$ Z8/Z9 | 36.5 | 34.5 | -2.0 |
| EURO$ Z9/Z0 | 7.0 | 6.0 | -1.0 |
| EUR | 123.07 | 122.91 | -0.16 |
| CRUDE (1st cont) | 61.92 | 62.41 | 0.49 |
| SPX | 2786.57 | 2752.01 | -34.56 |
| VIX | 14.64 | 15.80 | 1.16 |
https://www.chicagofed.org/publications/chicago-fed-letter/2017/386
https://www.newyorkfed.org/research/policy/underlying-inflation-gauge
