Policy Error, 2018
Weekly Comment – December 5, 2021
December euro$ midcurve options expire Friday. The front EDZ1 contract expires Monday, Dec 13. The FOMC meeting is December 15. Quarterly option expiration in equities is December 17.
The first four Fed meetings in the new year are Jan 26, March 16, May 4 and June 15. EDH2 expires March 14 and EDM2 expires June 13, both two days before the FOMC dates.
This week’s belatedly hawkish shift by Powell, retiring the word “transitory” and acknowledging a need to DISCUSS a more rapid taper sparked a massive curve move. On November 29, 2/10 spread was 102. Late Friday it was 75. The red/gold Eurodollar pack spread was just above 62 at Monday’s settle, and closed just below 32 on Friday. There is a tremendous amount of hand-wringing about the inversion in the back end of the Eurodollar curve. I will just note a few one-year calendars: EDH2/EDH3 settled 88, projecting 3 to 4 hikes over that year. EDH3/EDH4 settled 43. And EDH4/EDH5 at -2. Inversion at the back end. All I will say here is that inversion typically signals that the market perceives ‘too tight’ financial conditions which will lead to reduced growth or possible recession. The Sonia futures curve (UK rates) has led the move. One-year spreads there are 61, 1.5 and -10 for the three forward March year spreads.
In Q4 2018, Powell famously stated the Fed was no where near neutral as the Fed was hiking. The taper at that time had notched up to $50 billion per month. The Fed’s balance sheet was actually being pared down; it was shrinking as opposed to growing less rapidly, as is the current case. From the December 19, 2018 FOMC statement: “In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2-1/4 to 2-1/2 percent.” This was, of course the last hike and peak FF rate. In late September 2018 SP500 topped around 2914. By Thanksgiving it had lost nearly 10% to 2635 and bounced a bit, but by Dec 10 it was back at 2637. From Dec 10 to Dec 24 it dropped another 10%, bringing the total loss to 20% in three months. Mnuchin held calls on Sunday, Dec 23, 2018 with heads of the top six banks. Powell was forced into an embarrassing about-face.
In 2018 the high was ~2915. In November the high was just above 4700. After this week’s turmoil SPX is over 50% higher at 4538 than it was at the TOP of 2018, and about 3.4% off the high. I would say the risk of a further decline in stocks is greater now, given the torrid October/November rally. The point is that Powell is not going to re-live Q4 of 2018 by speeding up the taper. At the meeting, he will quell market calls for accelerating the timing of hikes. The Fed is facing policy errors in both directions. If he maintains the hawkish tilt, stocks crater and junk bond spreads blow out, which will force a policy reversal. If he pushes back on the idea of aggressive rate hikes to combat inflation, then price increases may accelerate. Long end treasury yields are giving him the cover to use option 2, as inflation concerns appear to be abating with a 14 bp plunge in the ten-yr yield on the week to 1.34%. My guess is that the upcoming week will contain a fair degree of volatility, which will solidify the choice of option 2.
The policy error that people are worried about has already occurred. The Fed was too loose for too long and created untenable valuation problems which have allowed the inflation narrative to set in. On Thursday, Yellen said “What we don’t want to have develop is a wage-price spiral, in which inflation becomes its own self-reinforcing kind of phenomenon that would become chronic in the US economy – something endemic.” This is what El-Erian, Summers, etc. have been arguing, that inflation is becoming self-reinforcing. The 5.9% cost-of-living increase to Social Security recipients is an example, but it’s surprising that someone in the Biden administration would openly suggest that workers’ wages might be growing too fast.
I have a rule (sometimes broken) “when you have a trade problem, do NOT compound it by doing something even more stupid.” Powell is not going to be pushed into repeating 2018. A firm dollar and declining long end rates buy him time. Slow and steady.
There was a trade Friday, a buy of 10k April ED 9862.5p for 1.5 covered EDM2 9949. The cover might have been 49.5; it doesn’t matter for this missive. That’s an astounding price. Because of the Easter holiday, these options expire on 14-April, Thursday. There are FOMC meetings Jan 26 and March 16. The May 4 FOMC is three weeks after April expires. These puts are going to expire worthless. My personal downside limit for EDM2 is 9930. OIS to Libor out to 18 bps. One hike expected in June and a chance of one in July. 9930 is not my target, it’s just that I think every put on EDM2 from the 9925 strike down will expire worthless. This is NOT A RECOMMENDATION to sell puts, but just for the sake of an example, EDM2 settled 9954.0. EDM2 9925p settled 6.5 and 9900p settled 3.75.
This week treasury auctions 3, 10 and 30 year paper Tuesday thru Thursday in size of $54b, $35b and $22b. These amounts are smaller than November by 2 billion in threes and 3 billion in both tens and thirties. However, in November the auctions raised just $43 billion in new cash as compared to $89 billion expected this week. (TBAC recommended finance table). From Tuesday through Friday the Fed will buy $24 billion in securities, though nearly $11 billion of that is in the 0 to 2.25 year maturity range on Wednesday. It’s hard to imagine that auctions will be well-received given much lower yield levels and the larger amount of new cash being raised, especially in longer maturities.
On Friday, the new 30-yr bondholders will be faced with CPI, expected 6.7% yoy with Core 4.9%. Previous levels were 6.2% and 4.6%. How does anyone justify buying the long-bond at 1.7% with CPI five percentage points higher!? It’s like the Dave Chappelle skit as the police officer taking a report on Jussie Smollett: “You left the house at 2am, it was minus 16 degrees and you were walking… to Subway.” Imagine the investor searching for an explanation from the bond buyer: “You were buying the auction at 1.7%, CPI is 6.2% with higher levels expected, and the Atlanta Fed GDPNow for Q4 is 9.7%. Oh, you thought that cash migrating from the near 20% drop in bitcoin on Saturday would go straight into long bonds. I see.”
Obviously there are a lot of geopolitical tensions and other issues that can lead to a risk-off environment which supports treasuries. But current yields don’t seem to provide adequate compensation given their own risk factors.
| 11/26/2021 | 12/3/2021 | chg | ||
| UST 2Y | 51.6 | 58.7 | 7.1 | |
| UST 5Y | 117.9 | 112.2 | -5.7 | |
| UST 10Y | 148.3 | 134.0 | -14.3 | w/I 135/34.5 |
| UST 30Y | 182.9 | 167.1 | -15.8 | w/I 168/67 |
| GERM 2Y | -75.6 | -74.3 | 1.3 | |
| GERM 10Y | -33.5 | -38.3 | -4.8 | |
| JPN 30Y | 67.3 | 66.3 | -1.0 | |
| CHINA 10Y | 285.8 | 290.3 | 4.5 | |
| EURO$ H2/H3 | 81.0 | 88.0 | 7.0 | |
| EURO$ H3/H4 | 55.0 | 43.0 | -12.0 | |
| EURO$ H4/H5 | 1.0 | -2.0 | -3.0 | |
| EUR | 113.18 | 113.14 | -0.04 | |
| CRUDE (active) | 68.15 | 66.26 | -1.89 | |
| SPX | 4592.62 | 4538.43 | -54.19 | -1.2% |
| VIX | 28.62 | 30.67 | 2.05 | |
https://home.treasury.gov/system/files/221/TBACRecommendedFinancingTableQ42021-11032021.pdf
