Regime Change
March 27, 2022 – Weekly comment
On Friday, Citi modified its rake hike forecast for 2022 to 275 bps. January 2023 FF fell 14.5 on Friday to 9759.5 or 2.405%, so the market is getting fairly close to pricing that outcome. With the current FF target 0.25 to 0.50 bps and six FOMC meetings left in the year, it implies that a majority of the meetings will feature 50 bp moves. A BBG article removes the implication and specifically states “Citigroup economists now seeing four straight half-point moves amid persistent inflation.” The NY Fed’s chief John Williams on Friday allowed that the Fed will hike 50 if it needs to. The Fed has become a completely reactive institution.
The ‘Regime Change’ title refers to a Fed that is now “…in inflation fighting mode” not to Biden’s adlibbed statement that Putin must be removed. Of course, the latter utterance may ultimately have more importance on the fate of the world. Speaking of fate, It was exactly 19 months ago on August 27, 2020 that the Fed formally adopted a different FAIT, or Flexible Average Inflation Targeting. This, as the country was being flooded with stimulus. Now the average inflation data has somewhat, well, overshot the target, leading to a story like this one from BBG, ‘A World That’s More Expensive is Starting to Destroy Demand’.
Let’s take housing as an example. In the beginning of 2022 the 30 yr mortgage rate was around 3.25%. According to a CNBC article by Diana Olick it’s now 4.95%. A mortgage loan of $350,000 started the year at just under $1525 per month. (Median home price at the end of the year was $408k). That same $350,000 mortgage at 4.95% is $1868 or over 22% higher. At the new higher rate of 4.95%, to keep the mortgage monthly payment at $1525 would mean a mortgage loan of just $286k rather than $350k. What impact does that have on the price of homes? The Fed’s Waller recently let it slip that the Fed would like to see home prices decline; I think he’s about to get his wish. The Homebuilder ETF, symbol XHB, is getting the message. Friday’s close is 23% lower than the price on Dec 31. However, the major stock indices appear oblivious to the inverse relationship between asset values and rates. I’ll always recall a friend of mine saying in 1999 that rising rates didn’t matter for the new dotcom tech companies, because they didn’t borrow, and therefore had no debt servicing costs. But what if the guy buying the shares DID borrow? Worse, what if he actually needs a stream of income rather than losses to service the debt? Mortgage applications were -8.1% last and the next release is Wednesday.
This week, there are treasury auctions of 2s, 5s and 7s on Monday and Tuesday. (WI yields Friday 2.31%, 2.545% and 2.55%). These yield levels are now the highest they have been since early 2019. Great news for savers, right? Finally! A shift favoring savers rather than spenders. Not so fast. The real 5y yield as approximated by the TIP is -1.15%, and the breakeven is a new record high 368 bps. Higher interest income more than vanishes when compared to inflation. Might as well keep spending. On Thursday, we’ll get the Fed’s preferred measure of inflation, Core PCE Prices, expected at a yoy rate of 5.5% vs 5.2 last. The last time it was 5.5% is when it was on its way down, 39 years ago in 1983. (In 1983 a severe drought took corn from 235 to 375, and beans from $6/bshl to $9.50. The first commercial mobile cellular phone call was made. Michael Jackson’s Thriller is the number one album. Monty Python’s The Meaning of Life is released). And then there’s this little tidbit:
September 26, 1983:
Stanislav Yevgrafovich Petrov (Russian: Станисла́в Евгра́фович Петро́в; 7 September 1939 – 19 May 2017) was a lieutenant colonel of the Soviet Air Defence Forces who played a key role in the 1983 Soviet nuclear false alarm incident.[1] On 26 September 1983, three weeks after the Soviet military had shot down Korean Air Lines Flight 007, Petrov was the duty officer at the command center for the Oko nuclear early-warning system when the system reported that a missile had been launched from the United States, followed by up to five more. Petrov judged the reports to be a false alarm.[2] His subsequent decision to disobey orders, against Soviet military protocol,[3] is credited with having prevented an erroneous retaliatory nuclear attack on the United States and its NATO allies that could have resulted in a large-scale nuclear war which could have wiped out half of the population of the countries involved. An investigation later confirmed that the Soviet satellite warning system had indeed malfunctioned. Because of his decision not to launch a retaliatory nuclear strike amid this incident, Petrov is often credited as having “saved the world”.
We’re completely reliant on technology these days. Let’s hope there’s a new Stanislav Petrov around to override both the technology and those who would unleash it.
https://en.wikipedia.org/wiki/Stanislav_Petrov
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Implied vol in interest rate products is exploding higher. Below is a graph of FV vol vs VIX. Both measures made highs on March 7, FV at 5.8 and VIX at 36.5. FV vol made a new high Friday. VIX has plummeted to 20.8 as stocks ripped higher post-FOMC. One of these is wrong.
As mentioned during the week, July 2023 Fed Funds and January 2024 Fed Funds are settling at exactly the same price, which was 9709.5 on Friday or 2.905%. The lowest contract on the FF curve is Sept 2023 at 9705.5. On the Eurodollar curve, the lowest contract is June’23 at 9684 or 3.16%, and on the SOFR curve it’s also June’23 at 9710.5. The market is therefore forecasting a peak FF target of 2.75-3.00% by the middle of next year, with no more hikes beyond that period (indeed, eases are priced thereafter).
| 3/18/2022 | 3/25/2022 | chg | ||
| UST 2Y | 195.3 | 229.7 | 34.4 | WI 233.5 |
| UST 5Y | 214.1 | 257.2 | 43.1 | WI 257.2 |
| UST 10Y | 214.4 | 249.0 | 34.6 | |
| UST 30Y | 241.5 | 260.2 | 18.7 | |
| GERM 2Y | -33.8 | -13.5 | 20.3 | |
| GERM 10Y | 37.3 | 58.7 | 21.4 | |
| JPN 30Y | 89.1 | 96.8 | 7.7 | |
| CHINA 10Y | 281.0 | 280.0 | -1.0 | |
| EURO$ M2/M3 | 131.5 | 154.5 | 23.0 | |
| EURO$ M3/M4 | -27.0 | -24.0 | 3.0 | |
| EURO$ M4/M5 | -22.5 | -18.0 | 4.5 | |
| EUR | 110.51 | 109.82 | -0.69 | |
| CRUDE (active) | 109.33 | 113.90 | 4.57 | |
| SPX | 4463.12 | 4543.06 | 79.94 | 1.8% |
| VIX | 23.87 | 20.81 | -3.06 |
