Hawkish Clarida highlights risks of changing Fed composition

August 5, 2021

–After a much weaker than expected miss in ADP drove interest rate futures to new highs, Clarida’s hawkish speech caused a sharp sell off.  As an example, EDZ3 (green Dec) had a large outside range day, popping up to 9923.0 on ADP and breaking to 9909.5 on Clarida, ending at 9912.0, down 5.5 on the day.  The ten year yield only finished 1 bp higher at 1.182%.  Once again, the greens (third year forward) are the weakest contracts, just as they were after the hawkish dot-plot at the June FOMC, which makes sense given that greens (3rd year) start with EDU’22 and Clarida cited year-end 2022 as a time fed funds could be raised.  Net changes by year: Whites +0.125, reds -3.0, greens -5.5, blues -4.5, golds -2.5.  

–Clarida’s term expires in January and his term as Vice Chair ends next month.  I have excerpted a few comments from the speech below.  Main points are: employment is a lagging indicator, but he cites 3.8% as full employment.  (I had a sense from Powell that 3.5% was full emp).  Risks to inflation are to the upside, but the Fed is outcome based (which means they are likely to be behind the curve).  If end of 2022 is a target for rate hikes, then the taper will happen fairly quickly.

–One large trade of interest is +36k 3EU 9875/9850/9825p fly vs -12k 9900/9912.5 c spread for 8.0, covered right in the middle at 9887, 50d.  The put fly settled 3.5 and the call spread at 3.25, so the package settled 7.25.

–The Treasury Borrowing Advisory Committee (TBAC) released recommendations yesterday which, in my opinion, dovetails nicely with a taper: reduced auction supply starting in November will partially offset less demand by the Fed. (Excerpt at bottom).  Does that mean that a taper will have no consequences on price action?  I think there WILL be consequences in that markets will perceive a withdrawal of liquidity at the margin going forward.  Supportive for the dollar, but not so much for stocks and bonds.https://home.treasury.gov/news/press-releases/jy0308

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excerpts from Clarida speech:

 transitioned from economic recovery to economic expansion.

 the recovery in employment has always lagged the recovery in GDP, and this cycle is no exception.

 First, if, as projected, core PCE inflation this year does come in at, or certainly above, 3 percent, I will consider that much more than a “moderate” overshoot of our 2 percent longer-run inflation objective. Second, as always, there are risks to any outlook, and I believe that the risks to my outlook for inflation are to the upside.

While, as Chair Powell indicated last week, we are clearly a ways away from considering raising interest rates and this is certainly not something on the radar screen right now, if the outlook for inflation and outlook for unemployment I summarized earlier turn out to be the actual outcomes for inflation and unemployment realized over the forecast horizon, then I believe that these three necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022.
My expectation today is that the labor market by the end of 2022 will have reached my assessment of maximum employment if the unemployment rate has declined by then to the SEP median of modal projections of 3.8 percent.
Indeed, under present circumstances, I judge that the support to aggregate demand from fiscal policy—including the more than $2 trillion in accumulated excess savings accruing from (as yet) unspent transfer payments—in tandem with appropriate monetary policy, can fully offset the constraint, highlighted in our Statement on Longer-Run Goals and Monetary Policy Strategy, that the ELB imposes on the ability of an inflation-targeting monetary policy, acting on its own and in the absence of sufficient fiscal support, to restore, following a recession, maximum employment and price stability while keeping inflation expectations well anchored at the 2 percent longer-run goal.
In light of these uncertainties, the Committee is rightly basing its judgments on outcomes, not just the outlook. 

TBAC:
Given the current fiscal and economic outlook, the Committee strongly supports coupon reductions beginning at the November refunding. The Committee estimates that beginning the adjustment in November rather than waiting until the February 2022 refunding results in about a $350 billion reduction in the amount of coupon debt outstanding, allowing the Treasury to maintain more T-bill supply for a given amount of coupon cuts. For November, the Committee recommends reductions of 2-, 3-, and 5-year securities by $2 billion per month. The Committee also recommends reductions of the 10-year security by $3 billion, and the 30-year security by $2 billion for both new issues and reopenings in the quarter.  For 7-year and 20-year securities, the Committee recommends declines of $3 billion and $4 billion, respectively2, which are somewhat larger than the declines in surrounding securities.  It was expected that, based on current fiscal and economic projections, these cuts would need to be sustained over a few quarters in order to maintain T-bills in the recommended range of 15 to 20% of total debt outstanding over time.  However, the Committee recognizes that a wide range of funding needs are possible and that Treasury would need to adapt issuance plans based on incoming information over time. The group acknowledged that while these reductions are sizeable, the gradual pace of the adjustment and the advance signaling of these changes would be generally in line with Treasury’s approach of regular and predictable issuance.

Posted on August 5, 2021 at 5:17 am by alex · Permalink
In: Eurodollar Options

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