Current Conditions

June 16, 2021

–Former NY Fed President Dudley often spoke about financial conditions.  In a speech from March 2017, he mentioned 5 key inputs, short term treasury rates, long term treasury rates, credit spreads, the value of the dollar, equity prices.  Going into today’s Fed meeting, 3-month libor is at a record low and bill rates are zero.  Then ten year yield is 1.5%.  Excluding the COVID plunge of 2020 it’s at the lowest level in five years.  Credit spreads are record lows.  DXY is near the year’s low. Stocks are record highs.  Housing is on fire with mortgage rates extremely low.  Federal deficits are at a record.  The financial press continues to talk about the dot plot.  My question is whether current financial conditions represent stability, or could be silently breeding instability.

–Regarding the dots, in March, 4 members saw one hike and one saw 2 hikes in 2022.  In 2023 there is 1 dot at 0.375, 1 at 0.625, 3 at 0.875, and 4 at 1.125.  Because these are end of year forecasts, it’s worth looking at Dec/Dec eurodollar spreads for comparison.  EDZ21/EDZ22 is 20.5 bps, not quite indicating one hike.  Jan’22/Jan’23 FF spread is 14.5, about a 50/50 chance for one hike in 2022.  So those spreads are more or less consistent with the plot.  EDZ’22/EDZ’23 is 54.5, about 2 hikes over that year which I would also terms as consistent with the plot.  Of course, “longer term”, the Fed expects the FF target to be around 2.5%, and nothing in the rate market is consistent with that.  Nothing.  If we compare that target to long term inflation expectations as represented by the ten year note to tip spread, which is 240 bps, then we might conclude that the Fed expects slightly negative real rates for the next ten years.  If we look at an average of the 4 euro$ contracts in year 2025, the avg price is 98.3075, which would be reasonable in the context of a FF target of 1.50.  About 100 bps BELOW the Fed’s longer term projections.

–In the March projections, the Fed looks for Core PCE Inflation at 2.2 in 2021, 2.0 in 2022 and 2.1 in 2023.  I’ll take the over, but the market has easily absorbed shockingly high prints.  The market trades as if Powell can gracefully transition to an initial conversation about tapering and eventual tightening.  I suppose the Fed should take that as a merit badge for guidance.  Enjoy it while it lasts.  

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

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