Nearer flatter, farther steeper
July 31, 2022 – Weekly comment
The big events of last week were the Fed’s (expected) 75 bp hike in the FF target to 2.25/2.50% equaling the high from 2018, and the Advance Q2 GDP print of -0.9%, signaling a recession that we’re going to pretend is not occurring.
In the wake of the FOMC meeting, the 2/5 treasury spread closed Friday at -21, at the lowest level since 2000. The red/green Eurodollar pack spread settled Friday -37.125. This is lower than all levels starting from 1999. Lows of approximately -10 in red/grn occurred in the year 2000 and in 2019. In June the record low since the turn of the century was posted at -39.75.
These spreads unambiguously reflect tight monetary policy. That policy was designed to restrain economic activity in order to squelch inflation, and the preliminary evidence is that demand is indeed being destroyed. On the inflation front, yoy PCE prices were +6.8% as expected, with Core a bit firmer than the survey at +4.8%. In terms of inflation expectations, the 5y breakeven hit a high of 368 in March, but the tightening campaign caused a favorable compression down to 229 by early July. In the past week the 5y b/e bounced from 234 to 279 as Powell toned down the tightening rhetoric. The October Fed Fund contract, (FFV2) which prices odds for the September 21 FOMC, had been halfway between 50 and 75 bps, but ended the week closer to 50 at a price of 9710 or 2.90%; 57 bps above the new Fed Effective rate of 2.33%.
While 2/5 spread is mired at new lows, the 5/30 treasury spread closed at its highest level since mid-March at 33 bps. On a technical basis there’s a double bottom at -17 which projects to around 70, which also happens to be the approximate halfway back point from the high in Feb of 2021 at 163 to the June 14 low of -17.
I would summarize price action as acknowledging very tight Fed policy, with hints of less hawkishness in the future, which encourages profit taking on short curve and long USD. Straddle prices in long dated red Eurodollar options offer further evidence that the market perceives somewhat less aggressive Fed action. For example, EDU3 9687.5 straddle settled on July 22 at 138 bps vs 9689.5. On Friday, the contract settled 9695.0 (+7.5 on the week) and the 9687.5^ settled 125.25 (-12.75 on the week). The 9700 straddle settled 124.5. All red straddles were down 13 to 17 bps; a significant mark-down of panic premium.
A large trade worth mention was Tuesday’s 67k block buy of the Dec’22/Dec’23 SOFR spread at -63 bps. The spread rallied to a high print of -46.5 by Wednesday afternoon, but gave back nearly all of that on Thursday and Friday, ending the week at -61.5. My interpretation is that the buyer expected a stronger signal of a near-term policy pivot. However, SFRZ2 settled at 9674.5 up only 6 bps on the week. The rate on SFRZ2 is 3.255%. In other words, the market’s forecast of a final year-end FF target around 3.25% didn’t much change. SFRZ2 settled 9674.5 and SFRZ3 settled 9736.0. The spread DOES indicate a pivot to easing next year. As always, timing is key.
Both the administration and the Fed have cited the strong labor market as one of the main reasons that the economy is NOT in recession. The employment report is Friday, with NFP expected 250k from 372k. The unemployment rate is expected unchanged at 3.6%. Jobless Claims have been slowly trending up since the historic low of 166k in mid-March to 256k last week.
| 7/22/2022 | 7/29/2022 | chg | ||
| UST 2Y | 299.1 | 289.7 | -9.4 | |
| UST 5Y | 287.5 | 269.3 | -18.2 | |
| UST 10Y | 278.7 | 264.3 | -14.4 | |
| UST 30Y | 300.3 | 297.7 | -2.6 | |
| GERM 2Y | 45.2 | 28.1 | -17.1 | |
| GERM 10Y | 103.1 | 81.7 | -21.4 | |
| JPN 30Y | 122.5 | 119.5 | -3.0 | |
| CHINA 10Y | 278.6 | 276.5 | -2.1 | |
| EURO$ U2/U3 | -27.5 | -25.0 | 2.5 | |
| EURO$ U3/U4 | -43.5 | -50.5 | -7.0 | |
| EURO$ U4/U5 | -5.5 | -13.5 | -8.0 | |
| EUR | 102.16 | 102.27 | 0.11 | |
| CRUDE (active) | 94.70 | 98.62 | 3.92 | |
| SPX | 3961.63 | 4130.29 | 168.66 | 4.3% |
| VIX | 23.03 | 21.33 | -1.70 | |
