Euro$ curve may signal end of Fed cycle
June 26, 2022 – Weekly comment
Once again Bullard referred back to 1994 as a parallel to tightening in this cycle. Below is a chart of the red/green Eurodollar pack spread which overlays the tightening schedule in 1994 (chart starts in late November 1993, amber) to the current time (chart starts late Jan 2021 in white).
I’m not sure how much can be gleaned here, but what is somewhat interesting is that this tightening cycle is much more aggressive than 1994 (see chart comment). Second, it’s either the Fed’s forward guidance or the fact that the market could clearly see inflation increasing that caused the red/green spread to flatten hard before the Fed ever even actually started to hike. In 1994 it was only after the November 75 bp hike that the red/green spread inverted. Before that, the Fed had already moved 175 bps in increments of 25 and 50. In the current case, this spread inverted in February, before the Fed ever moved.
After the November 75 bp hike in 1994, the Fed hiked one more time in a 50 bp clip in February 1995, bringing the terminal FF target to 6%. In February ’95 CPI was 2.9%, but it actually increased over the next couple of months to 3.2%. In any case the real FF rate was highly restrictive at about 3%. The point is that the curve had bottomed well before the final hike. By point of comparison, the red/gold pack spread made its 1994 low at the very end of the year at -27, and had rallied over 100 bps by June of 1995.
The forward looking nature of the markets makes it likely that these yield curve spreads bottom prior, but close to, the end of the Fed hiking cycle. In the present case, the red/green pack spread made a new low at -40 on June 13, just prior to the FOMC, but rallied afterward to -24. The red/gold pack spread hit a low of -87 on April 1, then rallied to -9 by early May. Just before the last FOMC, red/gold reached -60 on June 13, but has since snapped back to -11.5. So, while red/green made a new low in connection with the last FOMC, red/gold did NOT. These spreads appear to be telegraphing the strong possibility that the Fed is closer to the end of the hiking cycle than most analysts are forecasting.
The next FOMC is one month away, on July 27. Near contracts continue to lean heavily toward the idea of another 75 bp hike. For example, FFQ2 settled 9772.5 or 2.275%. Current Fed Effective (EFFR) is 158 bps, so another 75 bp hike would bring EFFR to 233 bps, or a price of 9767. Even the SF Fed’s Mary Daly is saying that she can support another 75 bp hike in July. At this point, it’s worth noting that as of November of last year in an interview with Reuters’ Brian Cheung, Daly was considering one 25 bp hike by the end of 2022 as appropriate. She was more or less in the mainstream, as the December SEP projection for the end of 2022 was 0.9%. The only point in singling out Daly is that Fed officials (and private professional economists) are often wrong in their forecasts, and today’s set of circumstances is particularly challenging.
My bias from this note, and in consideration of other market signals, is that buying red Eurodollar contracts and selling more deferred is the proper position, entering on pullbacks. This goes for treasury spreads as well, for example 5/10. The five-yr, ten-yr treasury spread made its low for the move on April 1 at -17, rallied by early May to +8.5, down to -12 by June 13 and ended the week at -6.
This week we’ll get to see how the market reacts to the release of the Fed’s preferred measure of inflation, Core PCE prices. This report is released on Thursdau June 30, and is expected yoy 4.8% vs last at 4.9%. The peak has been 5.3% at the end of February. A lower than expected number should put the odds for a Fed hike in July closer to 50 bps than 75. That is, FFQ2, on a number lower than 4.8 should end up closer to 9792 than 9767. (Friday settle 9772.5). Last Friday’s revision of UofM long-term inflation expectations from 3.3% to 3.1% already caused some analysts to pare back forward hike projections; keep an eye on the reds to forward contracts, a move to more positive levels would indicate that the Fed is nearing the end of the cycle.
Auctions this week: 2ss and 5s on Monday, 7s on Tuesday.
OTHER MARKET THOUGHTS/ TRADES
FFV/FFX settled 34 from 39.5 on the previous Friday. FOMC meeting on November 2. This spread now leans a bit closer to 25 bps than 50 for that meeting. There is likely to be intense political pressure on the Fed going into election day on November 8.
| 6/17/2022 | 6/24/2022 | chg | ||
| UST 2Y | 316.2 | 305.5 | -10.7 | |
| UST 5Y | 333.8 | 317.5 | -16.3 | |
| UST 10Y | 323.7 | 312.4 | -11.3 | |
| UST 30Y | 329.1 | 325.8 | -3.3 | |
| GERM 2Y | 109.4 | 81.3 | -28.1 | |
| GERM 10Y | 166.1 | 144.2 | -21.9 | |
| JPN 30Y | 116.8 | 123.0 | 6.2 | |
| CHINA 10Y | 281.4 | 284.9 | 3.5 | |
| EURO$ U2/U3 | 43.5 | 24.5 | -19.0 | |
| EURO$ U3/U4 | -38.5 | -36.5 | 2.0 | |
| EURO$ U4/U5 | -17.0 | -5.0 | 12.0 | |
| EUR | 104.99 | 105.58 | 0.59 | |
| CRUDE (active) | 107.99 | 107.62 | -0.37 | |
| SPX | 3674.84 | 3911.74 | 236.90 | 6.4% |
| VIX | 31.13 | 27.23 | -3.90 | |
Below are closes from Friday. For those who aren’t familiar with euro$ futures jargon, the contracts are 3 month consecutive periods. For example, EDU’22 will set to the three-month libor setting on 9/19/22 and that interest rate covers the three months from 9/21 until 12/21. The first four quarterly contracts cover one year, and are referred to as ‘fronts’ or whites. The second year forward, currently representing EDU’23, EDZ’23, EDH’24 and EDM’24 are the reds. The third year is greens, fourth is blues, fifth is golds. A pack is simply the four contracts averaged in price. Example, reds are EDU3 9650.5, EDZ3 9662.5, EDH4 9672.5 and EDM4 9681.5. The pack price is 9666.75. Therefore, a ROUGH approximation of yield for the second year forward is 3.3325%.
