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August 28, 2022 – Weekly Comment

Powell’s Jackson Hole speech:  No mention of “financial conditions”.  No mention of the dual mandate with “maximum employment”.* Focus is on bringing down inflation.  Like the Bundesbank of old.  No talk of soft landings.  From the speech, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.  These are the unfortunate costs of reducing inflation.”  No mention of the effect of energy prices. 

Including the title, ‘Price stability’ is cited ten times in a speech that only has 15 paragraphs.  Driving home a point.

The hand-wringing about whether the Fed hikes 50 or 75 at the September meeting is a tree.  We’re in the forest.  Again from Powell’s speech, “That brings me to the third lesson, which is that we must keep at it until the job is done.”  Powell did acknowledge that the pace of hikes would eventually slow.  But the idea of a pivot is out Bastiat’s broken window.

Apart from Powell, Bullard said he’s “hopeful we get upward pressure on rates through QT.”  About 40 minutes prior to Powell’s speech a Reuters article came out which said “Some ECB policymakers want to discuss a 75 bp interest rate hike at the September policy meeting, even if recession risks loom.”  ERZ2 (December Euribor) instantly dropped from 9854 to 9834.  From Sunday morning’s FT site: ECB Officials warn of ‘sacrifice’ needed to tame surging inflation.  This, as Holger Zschaepitz notes that German forward electricity prices have “skyrocketed to almost €1000 per megawatt hour.  The electricity price has risen by 720% ytd.”  I’d call that a sacrifice at the energy altar.

Of course. stocks got the message.  On Friday, SPX was down 3.4% and Nasdaq down 3.9%.  On the week SPX was down 4%.  YTD numbers: SPX -15.4%, Nasdaq Comp -23%, DJIA -11.8%.  As an indication of real estate woes, Zillow Group stock is down 46% ytd.  The takeaway for companies is, ‘we’re going to make it more difficult to raise prices’.  Even if energy prices are siphoning away consumer purchasing power, the central bank is NOT going to provide accommodation.  Zombies are going to have a much more difficult time with funding.

In other words, ‘There will be pain, but we’re going to stick to it.’  The question in markets is, ‘Can the Fed really take the political pressure associated with much more significant drops in asset prices?’ 

Short end curves provide some clues, and the short answer is NO, the Fed won’t be able to shoulder the pressure.  One-yr forward calendar spreads in Eurodollars are a rough guide for determining whether the market perceives the Fed to be tilted toward easing or hiking. (Same with SOFR of course, but I am using ED because of historical data availability).  When the Fed is in a tightening regime, forward spreads are typically positive.  That is, longer dated contracts are lower in price and higher in yield than nearer contracts.  However, on the current euro$ strip, out to a few years, the only positive spread is EDU2/EDU3, the nearest spread, which settled Friday at positive 44.5 (9662.5/9618.0), a new high since mid-June (the low settle in July was -31).  Currently, the lowest, most inverted, spread on the ED curve is EDM3/EDM4 at -66.  The low settle in this spread on August 15 was -81.5.  The market still perceives that the Fed will be easing sometime by the middle or end of next year. Powell’s speech SHOULD cause these spreads to move more positive, and indeed a few did, but it’s pretty clear that the market does NOT think the Fed is going to be able to hold rates at more restrictive levels as the economy cools, especially if asset prices are crumbling.  Below is a long term chart of the 4^th to 8^th quarterly, currently EDM3/EDM4.  While this is currently the lowest spread, when the market is absolutely convinced easing is around the corner, it is the NEAR spreads that become most inverted.  In early September 2019, the 1^st to 5^th had a low of -85 and 2^nd to 6^th had a low -63.5.   Currently 1^st to 5^th is EDU2/U3 at +44.5 and 2^nd to 6^th is EDZ2/Z3 at -36.5.

In terms of trades, the higher for longer Fed outlook should mean that something like EDM3/EDM4 is an easy buy.  But if the Fed wavers, it’s not clear cut.  And, with this particular Fed board, there are likely to be a lot of speeches at odds with Powell’s clear and direct message, especially after the September 21 FOMC.  The picture will likely become more muddled.  On top of that, midterm elections are just after the Nov 2 FOMC, which might make that meeting more political than usual. 

Therefore, the types of trades that make sense are put spreads, and butterflies, and for those who perceive a cap to the terminal rate, put trees, on late 2023 through 2024 contracts. Trades of this type have already occurred.  Indeed last week I had suggested that EDZ4 should at least test 9683.5 from 9697, and in fact, EDZ3 settled Friday exactly at that level.  On Thursday there was a buyer of over 50k 0QZ2 9650/9600/9550 put fly for 8.5.  This is a midcurve based on SFRZ3 expiring Dec 16, 2022.  Settled 8.5 on Friday ref SFRZ3 9661.0.

News this week is capped off by the employment report on Friday.  ISM Mfg is Thursday.  Economic data have been showing weakness, though last NFP was 528k.  I anticipate more equity market selling in the early part of the week, which may support fixed income in the short term.  CPI is released on Sept 13, and there’s a 30y bond auction also on that day.  The long end of the curve continues to trade bearishly; Sept 13 could be a big date.

	8/19/2022	8/26/2022	chg
UST 2Y	326.0	338.6	12.6
UST 5Y	310.9	319.3	8.4
UST 10Y	298.3	303.3	5.0
UST 30Y	322.1	320.3	-1.8
GERM 2Y	82.4	98.7	16.3
GERM 10Y	123.0	139.0	16.0
JPN 30Y	107.9	114.1	6.2
CHINA 10Y	263.0	266.0	3.0
EURO$ U2/U3	33.8	44.5	10.8
EURO$ U3/U4	-56.0	-58.0	-2.0
EURO$ U4/U5	-28.5	-23.5	5.0
EUR	100.40	99.66	-0.74
CRUDE (active)	90.44	90.44	0.00
SPX	4228.48	4057.66	-170.82	-4.0%
VIX	20.60	25.56	4.96

^ (h/t Doug Noland, Credit Bubble Bulletin
http://creditbubblebulletin.blogspot.com/

https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm

• 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.