Leaning Gently Towards Ease
November 18, 2023
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Tweet by Bill Gross on Friday, November 10.
“The best interest rate trade is to bet on a disinversion of the curve. The US economy needs a positive curve to grow as fiscal stimulus wanes. The curve can disinvert by 10 year notes going up, 2 years going down, or both. But a year from now the current negative spread of 40 bps will be positive.”
In the week since the Gross tweet above, 2/10 fell by about 5 bps to -46.8 on Friday. However, on the longer term chart above that move is simply noise. On a technical set up, there’s a double bottom from just before the regional banking jolt in March at -109, which was subsequently retested in July. The intervening high range of -57 to -40 should now act as support. The halfway point between the 2021 high of +157 and the low of -109 is -24, which is near the same level as when the first rate hike occurred in March 2022. (FF midpoint target in yellow).
An inverted curve is a sign of a tight central bank, and despite the good CPI news last week, the Fed does not want to portray an easy posture with inflation still above target and a Federal Gov’t that shows little inclination towards fiscal restraint. However, as Michael Ashton (@inflation_guy) notes in his Quarterly Inflation Outlook :
Inflation is coming down, but is not likely to reach the Fed’s goal very quickly. Unemployment is rising. The Fed’s dual mandate goals are therefore in conflict. The difficult part of monetary policymaking has just begun.
The market respects this view. There are a lot of trades being placed for the possibility of easing in the new year, but they are mostly in the form of clearly defined risk/reward call structures (more on that below). In terms of the Fed Funds futures ‘forecasts’ for rates, note the following spreads:
January’24/January’25 spread settled -92.0. FFF4 settled 9467.0, exactly at the current Fed Effective rate of 5.33% while FFF5 settled 9559.0, not quite 100 bps lower in yield. There is an FOMC meeting Jan 31, so odds for a Fed move at that meeting are clearly embedded in the Jan/Feb spread. FFF4 settled 9467 and FFG4 settled at the exact same price, i.e. unchanged policy. The Feb/April spread isolates the March 20 FOMC. That spread settled 9467.0 vs 9474.0 or -7 and traded as low as -8.5 last week. So around a 30% chance of a March ease of 25 bps. Beyond that, April/May spread captures the May 1 FOMC, prices are 9474.0/9585.0 or -11. May/July for June 12 FOMC, 9485.0/9499.5 or -14.5. July/Aug for July 31 FOMC, 9499.5/9513.0 or -13.5. All around 50/50 for 25 bp eases.
The five-year note yield fell about 21 bps last week to 4.45%. On the SOFR curve, the largest change was SFRZ5, up 24 bps to 9622.0. The 2026 SOFR contracts are the high point of the curve, with settles from 9622.5 to 9621.5, or 3.78%, but these contracts are more than two years forward.
On Friday, the theme of targeted Fed ease trades continued. As examples:
BUYER 25k SFRF4 9468.75/9475/9493.25/9500 c condor from 2.25 to 2.5. Max settle value is 6.25 bps between the two center strikes, and underlying SFRH4 settled 9476.0. Ideal outcome is that perceived easing in Q1 stays right around current levels. Expiration on Jan 12 is well before the Jan 31 FOMC.
BUYER 7k SFRM4 9500/9550c 2×3 for 13.5 to 14.0. Settled 12.75 (30.0/15.75) ref 9500.0. Same traded in May for 16.0. Breakeven in June using 14 is 9622 which is currently the peak level on the SOFR curve, as mentioned above. SFRM4 settled Friday 9500.0.
BUYER 20k SFRM4 9512.5/9537.5/9562.5c fly for 2.5. Max value of 25 with a settle of 9537.5, consistent with about 75 bps of ease (SFRZ3 currently 9462.5).
Since Q4 2022, the ten year breakeven, treasury – tip yield, has been between 2.55% and 2.10%. Last at 2.27%, pretty close to the Fed’s 2% target. The Treasury auctions 10y tips on Tuesday. The current 10y tip is 2.16%. This ‘real’ yield had been negative in the two years from 2020 to 2022, finally moving decisively above 0 in May 2022, around the time of the second Fed hike, which was 50 bps, taking the target to 0.75-1.00%. The cap has been just above 2.5% this year.
On Monday the Treasury auctions $16b of 20 year bonds. This is the high point on the treasury curve. Late Friday w/I was 4.785%. A poor 30-yr auction on November 9 saw the yield jump to 4.77%, but since then 30s have reversed the move to come back down to 4.59%, the lowest since late September. The 20-yr might still be an important gauge of demand.
| 11/10/2023 | 11/17/2023 | chg | ||
| UST 2Y | 506.0 | 490.5 | -15.5 | |
| UST 5Y | 466.4 | 445.1 | -21.3 | |
| UST 10Y | 462.8 | 443.7 | -19.1 | |
| UST 30Y | 473.2 | 459.2 | -14.0 | |
| GERM 2Y | 306.6 | 296.4 | -10.2 | |
| GERM 10Y | 271.7 | 258.8 | -12.9 | |
| JPN 20Y | 154.9 | 146.7 | -8.2 | |
| CHINA 10Y | 264.8 | 265.8 | 1.0 | |
| SOFR Z3/Z4 | -81.0 | -97.3 | -16.3 | |
| SOFR Z4/Z5 | -57.5 | -62.5 | -5.0 | |
| SOFR Z5/Z6 | -1.0 | 0.5 | 1.5 | |
| EUR | 107.18 | 109.20 | 2.02 | |
| CRUDE (CLF4) | 77.15 | 76.04 | -1.11 | |
| SPX | 4415.24 | 4514.02 | 98.78 | 2.2% |
| VIX | 14.17 | 13.80 | -0.37 | |
